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  • Writer's pictureWing Chan

When Life Insurance Inheritance Tax Takes Place

Updated: Oct 10, 2023

What is Inheritance Tax on Life Insurance? When most people think of inheritances, property, heirlooms, and other assets come to mind, but you could pay tax on life insurance proceeds as well. In general, inheritance tax is simply a percentage taken by tax authorities from anything that constitutes unearned income from someone who has passed away. Sometimes, you might hear people and resources refer to this as an estate tax because it more clearly includes every element of the deceased persons wealth and property left to the surviving. But, the IRS and states define inheritances and estates differently, meaning multiple tax categories could apply. When a life insurance policy specifies that its payouts should be placed in the policyholders estate, there is the possibility that death benefits will be taxed, but only in certain circumstances. In the majority of situations, designating an individual to be the beneficiary of the policy will make the death benefit completely tax free. Several factors go into whether an estate and its life insurance benefits are considered taxable. These often include:

  1. Estate Property Value

  2. State-based Regulations

  3. Beneficiary Relationship

  4. Secondary Beneficiaries

  5. Type of Insurance Benefit To see if these apply to you, here is a brief overview of the kinds of features that will make your life insurance taxable as a qualifying inheritance. As you consider them, note the ways that making an estate a beneficiary rather than an individual could significantly reduce the effectiveness of your insurance policys financial protection. Then, you can decide how to retain as much value as possible.

The Value of the Estate If the estate of the deceased receives the death benefit of a life insurance policy, the IRS will decide to apply tax on it when the total value of the estate is considerable. For example, when all assets are assessed to be worth more than $11.7 million, estate tax begins at the federal level. States with their own estate and separate inheritance conditions have different standards and limits for each kind of tax you could pay on your life insurance benefits. For those who stand to inherit large amounts of property, valuable physical or financial assets, and hefty life insurance income, its crucial to consider which states might impose taxes on top of federal requirements as well as what these rates are.

States with Estate Tax Most beneficiaries wont need to worry, but 12 states have determined that it benefits their residents to impose an inheritance tax. If you are an heir to it, an estate can also bring taxes and act as a tax on your inheritance by effect. While these stateslike taxation at the federal levelwill impose different rates on the total value of the estate and inheritance, several ways exist to ensure that assets or income are protected from unnecessary loss. For example, life insurance can be given to certain, exempt people in your life even when considered an inheritance.

Relationship to the Deceased Whether or not your estate has an inheritance tax, beneficiaries who are the spouse of the deceased will never suffer excessive state taxes on what they inherit. That means insurance benefits and proceeds that might be considered an inheritance by their standards wouldnt pay the rate even beyond the defined limits above. In Maryland, for example, this is also true of domestic partners in joint residence. Also, children and grandchildren arent taxed as part of an inheritance in most states with such a policy. (Pennsylvania and Nebraska still will.) However, in some states like Nebraska, you will pay tax as an extended relative such as a niece or nephew. In most cases, if you are not related as part of the benefactors family, youll be taxed to the greatest extent.

Indirect Receipt of Death Benefits As a policyholder, you may intend to directly give the proceeds of your life insurance policy to those you aim to protect. Such giving is never taxed as gross income at the federal level. However, the possibility of taxation exists when it is converted to an estate if the primary beneficiary dies shortly after you and before the policy proceeds can be claimed. For instance, if a spouse has a right to the benefits of the policy, but they pass away before the insurance company processes and approves the payment, then the proceeds will go into their estate. Even if you select a secondary beneficiary, the death benefits will convert in this sense introducing the opportunity for paying out the tax rate states and the IRS determine for inheritances. Most simply, this is because the primary beneficiary received and has a right to those benefits before the secondary beneficiary. Though this is usually only a concern for highly valuable estates that meet the limits set out by tax law, it still represents unpleasantness for many people in states with lower limits than the $11.7 million that the IRS sets out.

Income-Generating Proceeds of Insurance When life insurance benefits are converted or given to an estate and those proceeds generate incomethrough interest or investment for exampletax is also introduced on these assets. While this is not a strict and direct form of inheritance tax, it does concern those who want to be smart about how to proceed with structuring their policy. If the beneficiaries or unintended, extended heirs of the estate gain proceeds generated from an investment or asset as part of the policy, the estate will be held to the appropriate tax rate. This is simply because all interest payments are taxable according to the IRS and federal tax law, and there is no avoiding this rule for those who receive benefits in installments to increase the value of the death benefits. When they accrue interest, tax does not apply to the original amount of the policy, but, instead, on the amount grown from that lump sum afterward. If a policyholder wants their heirs and beneficiaries to avoid high taxes, they can find other ways of structuring a policy so that the proceeds dont contribute to earned income, put them over the threshold for state inheritance tax, or constitute a taxable asset.

Tax-Free Life Insurance Options for Estates and Heirs While there are many ways for taxation to occur for those with large estates, there are also several structures for avoiding unnecessary cuts to profits. To reduce the chance of being taxed on their life insurance inheritance, trusts can be useful. An irrevocable life insurance trust, for example, can transfer ownership of the policy to a trust rather than to the trustee. Then, you can decide who you would like to take the role of trust beneficiary. In this way, an irrevocable life insurance trust can prevent taxes on the estate after an impressive death benefit. Nevertheless, there are even more ways that taxes can take from the estate even with this thoughtful plan. If the life insurance proceeds include cash value that exceeds the gift exemption described by the IRS, then you may need to pay gift tax. Such a rate pales in comparison to inheritance and estate taxes on heirs, but they remain a consideration. Most people choose, though, to give simply and directly to individualsbut taxes may apply even with the best-laid plans. Other technical aspects of tax law and its category definitions often require an attorney and advisors to plan for large and complex estates, but these are the situations we see when beneficiaries are forced to pay a good portion of their benefit income to the state and federal government.

Secure Death Benefits through Personalized Life Insurance Losing benefits before they can help your beneficiaries' lives and continue your legacy through heirs to your estate can frustrate everyone involved. While you should ask more of a policy than simply a low premium and a high benefit amount, you also must consider which structures are least likely to be taxed given your unique circumstances. Planning your policy to be personalized to you makes it most likely that the policy will suit your family and step outside the categories that bring the heaviest taxation. In some ways, foreseeing the most unlikely and unfortunate events (such as the death of your beneficiaries) should be part of your policy planning. Inheritance tax can come on its own in several states, but estate and asset taxes can equally act as taxes on an inheritance. Its important to choose a policy by shopping with Sproutt to maximize protection for your heirs.

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