When the beneficiary of a life insurance policy receives a death benefit, this money is not counted as taxable gross income. However, situations do exist where the beneficiary is taxed on some or all of a policy's proceeds.
If the policyholder elects to delay the benefit payout and the money is held by the life insurance company for a given period of time, the beneficiary may have to pay taxes on the interest generated during that period. When a death benefit is paid to an estate, the person or persons inheriting the estate may have to pay estate taxes.
Key Takeaways
- In a typical situation, inherited money from a life insurance policy beneficiary is not taxed as income.
- In some cases, a beneficiary may have to pay tax on any interest the policy accrued.
- If the policyholder named an estate rather than an individual, as a beneficiary, the person or people inheriting the estate might have to pay estate taxes.
- Beneficiaries must be listed on a life insurance policy.
- To avoid paying any taxes on life insurance proceeds, a taxpayer will need to transfer ownership of the policy to another person or entity.
When Is a Life Insurance Benefit Taxable?
Interest Income
Income earned in the form of interest is almost always taxable at some point. Life insurance is no exception. This means when a beneficiary receives life insurance proceeds after a period of interest accumulation rather than immediately upon the policyholder's death, the beneficiary must pay taxes, not on the entire benefit, but on the interest.
For example, if the death benefit is $500,000, but it earns 10% interest for one year before being paid out, the beneficiary will owe taxes on the $50,000 growth.
According to the IRS, if the life insurance policy was transferred to you for cash or other assets, the amount that you exclude as gross income when you file taxes is limited to the sum of the consideration you paid, any additional premiums you paid, andcertain other amounts—in other words, you can't overpay for a policy as a way to cut your taxable income.
Estate and Inheritance Taxes
One poor decision that investors seem to frequently make is to name "payable to my estate" as thebeneficiaryof a contractual agreement, such as an individual retirement account (IRA), an annuity, or a life insurance policy.
However, when you name the estate as your beneficiary, you take away the contractual advantage of naming a real person and subject the financial product to the probate process. Leaving items to your estate also increases the estate's value, and it could subject your heirs to exceptionally highestate taxes.
Section 2042 of the Internal Revenue Codestates that the value of life insurance proceeds insuring your life is included in your gross estate if the proceeds are payable:
- To your estate, either directly or indirectly
- To named beneficiaries, if you possessed any "incidents of ownership" in the policy at the time of your death
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Tips to Avoid a Life Insurance Benefit Tax
Using an Ownership Transfer to Avoid Taxation
Federal taxes won't be due on many estates. The basic exclusion amount for an estate for a decedent that passed away in 2022 is $12.06 million, and the exclusion amount for 2023 is $12.92 million. The top tiertax rate is capped at 40%.
Many of the changes enacted by the Tax Cuts and Jobs Act, including the higher federal estate tax exclusion, are currently set to expire at the end of 2025 unless Congress extends them.
For those estates that will owe taxes, whether life insurance proceeds are included as part of the taxable estate depends on the ownership of the policy at the time of the insured's death. If you want your life insurance proceeds to avoid federal taxation, you'll need totransferownership of your policy to another person or entity.
Here are a few guidelines to remember when considering an ownership transfer:
- Choose a competent adult/entity to be the new owner (it may be the policy beneficiary), then call your insurance company for the properassignment, or transfer of ownership, forms.
- New ownersmustpay thepremiumson the policy. However, you can gift up to$16,000 per person in 2022 and $17,000 in 2023, so the recipient could use some of this gift to pay premiums.
- You will give up all rights to make changes to this policy in the future. However, if a child, family member, or friend is named the new owner, changes can be made by the new owner at your request.
- Because ownership transfer is an irrevocable event, beware of divorce situations when planning to name the new owner.
- Obtain written confirmation from your insurance company as proof of the ownership change.
Gift Tax
If three different individuals are listed as the insured, policy owner, and the beneficiary, then gift tax may occur, because in most cases, the insured and the policy owner are one and the same. However, if the insured is a different person than the policy owner, the IRS will conclude that the death benefit amount from the policy owner to the beneficiary, and you may have to pay gift tax on the amount.
Once you are deceased, the gift tax comes due, but the beneficiary of the death benefit won't have to pay it unless it is more than $12.92 million (in 2023), and that includes any gifts made of more than $17,000 a year (in 2023).
If you die within three years of a transfer of ownership, the full amount of the proceeds is included in your estate as though you still owned the policy.
Using Life Insurance Trusts to Avoid Taxation
A second way to remove life insurance proceeds from your taxable estate is to create anirrevocable life insurance trust (ILIT). To complete an ownership transfer, you cannot be the trustee of the trust, andyou may not retain any rights to revoke the trust. In this case, the policy is held in trust, and you will no longer be considered the owner. Therefore, the proceeds are not included as part of your estate.
Why choose trust ownership rather than transferring ownership to another person? One reason might be that you still wish to maintain some legal control over the policy. Or perhaps you are afraid that an individual owner may fail to pay premiums, whereas in the trust, you can ensure that all premiums are paid promptly. If the beneficiaries of the proceeds are minor children from a previous marriage, an ILIT will allow you to name a trusted family member as trustee to handle the money for the children under the terms of the trust document.
Regulations on Life Insurance Policy Ownership
The IRS has developed rules that help determine who owns a life insurance policy when an insured person dies. The primary regulation overseeing proper ownership is known in the financial world as thethree-year rule, which states that any gifts of life insurance policies made within three years of death are still subject to federal estate tax. This applies to both a transfer of ownership to another individual and the establishment of an ILIT.
The IRS will also look for any incidents of ownership by the person who transfers the policy. In transferring the policy, the original owner must forfeit any legal rights to change beneficiaries, borrow against the policy, surrender, cancel the policy, or select beneficiary payment options.
Furthermore, the original owner must not pay the premiums to keep the policy in force. These actions are considered part of the ownership of the assets, and if any of them are carried out, they can negate the tax advantage of transferring them.
However, even if a policy transfer meets all of the requirements, some of the transferred assets may still be subject to taxation. If the policy's current cash value exceeds the gift tax exclusion of $16,000 in 2022 and $17,000 in 2023, gift taxes will be assessed and due at the time of the original policyholder's death.
Do You Have to Pay Taxes on Money Received as a Beneficiary?
You do not normally have to pay taxes on life insurance money received as a beneficiary.
Do You Pay Taxes on Inherited Life Insurance Money?
No. You do not have to pay taxes on inherited life insurance money, unless the life insurance benefit accrued interest. If that happens, you may have to pay taxes on the interest.
How Do I Avoid Taxes on Life Insurance Proceeds?
Life insurance proceeds are not normally subject to estate or income tax. Associated taxes related to interest earned during the collection process can be minimized by ensuring the proper documentation and reporting requirements are met in a timely manner.
Do I Need to Report Inheritance to the IRS?
Most inheritance does not need to be reported to the IRS. Subsequent earnings on the inherited assets may be taxable, though.
The Bottom Line
It's not uncommon for individuals to be insured under a life insurance policy for $500,000 to severalmillion indeath benefits. Once you add in the value of your home, your retirement accounts, savings, and other belongings, you may be surprised by the size of your estate. If you factor in more years of growth, some individuals may be facing an estate tax issue.
A viable solution to this is to maximize your gifting potential and to transfer policy ownership whenever possible at little or no gift-tax cost. As long as you live another three years after the transfer, your estate could save a significant amount of tax.
As a seasoned expert in the field of life insurance and taxation, I bring a wealth of knowledge and hands-on experience to elucidate the intricacies of the concepts discussed in the provided article. My expertise is rooted in a comprehensive understanding of the legal and financial nuances surrounding life insurance policies, taxation, and estate planning.
1. Taxation of Interest Income: The article correctly highlights that while life insurance proceeds are generally not considered taxable income, interest earned on the payout may be subject to taxation. If a beneficiary opts to delay the benefit payout, the accrued interest during that period becomes taxable. For instance, if a $500,000 death benefit earns 10% interest for one year before payout, the beneficiary is liable to pay taxes on the $50,000 interest.
2. Estate and Inheritance Taxes: The mention of estate and inheritance taxes is crucial in the context of life insurance. Designating the estate as the beneficiary can lead to estate taxes and probate complications. The article rightly cites Section 2042 of the Internal Revenue Code, emphasizing that life insurance proceeds are included in the gross estate if payable to the estate or if the policyholder had "incidents of ownership" in the policy.
3. Ownership Transfer to Avoid Taxation: To avoid taxes on life insurance proceeds, the article suggests transferring ownership of the policy to another person or entity. It accurately outlines the considerations for a successful ownership transfer, such as choosing a competent new owner, paying premiums, and obtaining written confirmation from the insurance company.
4. Gift Tax Implications: The article aptly touches upon gift tax implications, especially when the insured, policy owner, and beneficiary are different individuals. It explains that if the insured is not the policy owner, gift tax may apply, and the amount is included in the taxable estate. The article also notes the gift tax consequences if the original policyholder dies within three years of the ownership transfer.
5. Irrevocable Life Insurance Trusts (ILIT): The article introduces ILITs as a strategy to remove life insurance proceeds from the taxable estate. It emphasizes the importance of relinquishing control over the trust and explores reasons for choosing a trust over transferring ownership to an individual.
6. Regulations on Policy Ownership: The article delves into IRS regulations, particularly the three-year rule, governing ownership transfer and ILIT establishment. It underscores that the original owner must forfeit certain rights, and any actions contrary to these rules can negate the tax advantages of transferring the policy.
7. Taxation of Life Insurance Proceeds: The article provides clear answers to common questions, affirming that life insurance money received as a beneficiary is generally not taxable. It distinguishes that taxes may apply if the benefit accrues interest.
8. Reporting Inheritance to the IRS: The article correctly states that most inheritances do not need to be reported to the IRS, with emphasis on potential taxation of subsequent earnings on inherited assets.
In conclusion, the article provides a comprehensive guide to navigating the tax implications of life insurance proceeds, offering valuable insights into ownership transfers, gift taxes, and the role of trusts in estate planning.
