Do Beneficiaries Pay Taxes on Life Insurance?

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Do Beneficiaries Pay Taxes on Life Insurance?

When a life insurance policy’s beneficiary gets a death benefit, the money is not considered taxable gross income. However, there are instances when the recipient gets taxed on part or all of the profits of an insurance.

If the policyholder chooses to postpone the benefit distribution and the funds are kept by the life insurance company for a certain amount of time, the recipient may be required to pay taxes on the interest earned during that time. When a death benefit is provided to an estate, the individual or individuals who inherit the estate may be required to pay estate taxes.

Key Takeaways

  • In most cases, money inherited from a life insurance policy recipient is not taxed as income.
  • In rare situations, a beneficiary may be required to pay tax on any interest earned by the insurance.
  • If the policyholder designated an estate as a beneficiary rather than an individual, the person or individuals receiving the estate may be required to pay estate taxes.
  • A life insurance policy must include a list of beneficiaries.

When Is a Life Insurance Benefit Taxable?

Interest Income

Interest income is usually always subject to taxation at some time. Life insurance is no different. This implies that if a beneficiary gets life insurance payments after a period of interest accumulation rather than immediately upon the death of the insured, the recipient must pay taxes on the interest rather than the whole benefit.

For example, if the death benefit is $500,000 but earns 10% interest for one year before being paid out, the recipient must pay taxes on the $50,000 increase.

According to the IRS, if the life insurance policy was transferred to you in exchange for cash or other assets, the amount you can deduct as gross income when filing taxes is limited to the sum of the consideration you paid, any additional premiums you paid, and certain other amounts—in other words, you can’t overpay for a policy to reduce your taxable income.

Estate and Inheritance Taxes

One common mistake that investors appear to make is naming “payable to my estate” as the beneficiary of a contractual arrangement, such as an IRA, an annuity, or a life insurance policy.

However, designating the estate as your beneficiary eliminates the contractual benefit of naming a real person and subjects the financial product to the probate procedure. Leaving assets to your estate enhances the worth of the estate and may expose your heirs to extraordinarily high taxes.

The value of life insurance profits guaranteeing your life is included in your gross estate under Internal Revenue Code Section 2042 if the funds are payable:

  Determining Adjustments to Income on Your Tax Return

  1. Directly or indirectly to your estate
  2. If you have any “incidents of ownership” in the insurance at the time of your death, they will be paid to the designated beneficiaries.

Tips to Avoid a Life Insurance Benefit Tax

Using an Ownership Transfer to Avoid Taxation

Many estates will be free from federal taxes as a result of the Tax Cuts and Jobs Act (TCJA) of 2017, which boosted the exemption level to $11.7 million for 2021 and $12.06 million for 2022. In the meantime, the maximum estate tax rate is set at 40%.

Many of the Tax Cuts and Jobs Act’s provisions, such as the increased federal estate tax exclusion, are due to expire at the end of 2025 unless Congress extends them.

The ownership of the policy at the time of the insured’s death determines whether life insurance profits are included as part of the taxable estate for those estates that would owe taxes. To avoid federal taxes on your life insurance earnings, you must transfer ownership of your policy to another person or corporation.

When contemplating an ownership transfer, keep the following principles in mind:

  1. Choose a competent adult or organization to be the new owner (it might be the policy beneficiary), then contact your insurance provider for properassignment, or ownership transfer, documents.
  2. The policy’s premium must be paid by the new owner. You may, however, give up to $15,000 per person in 2021 and $16,000 in 2022, so the receiver might use portion of this gift to pay premiums.
  3. You will relinquish all future rights to amend this policy. If a kid, family member, or friend is designated the new owner, the new owner may make modifications at your request.
  4. Because ownership transfer is an irreversible occurrence, avoid naming the new owner in divorce scenarios.
  5. As evidence of the ownership change, get official confirmation from your insurance carrier.

Gift Tax

Gift tax may apply if three separate people are identified as the insured, policy owner, and beneficiary, since the insured and policy owner are usually the same person. If the insured is not the same person as the policy owner, the IRS will decide that the death benefit amount was transferred from the policy owner to the beneficiary, and you may be required to pay gift tax on the amount.

When you die, the gift tax becomes payable, but the recipient of the death benefit is exempt from paying it until the amount is more than $12.06 million, which includes any donations of more than $16,000 per year.

  Retirement Accounts Abroad

If you die within three years of transferring ownership, the profits are included in your estate as if you still held the insurance.

Using Life Insurance Trusts to Avoid Taxation

An irrevocable life insurance trust is a second approach to keep life insurance payments out of your taxable estate (ILIT).You cannot be the trustee of the trust or maintain any powers to cancel the trust in order to execute an ownership transfer. In this instance, the insurance is held in trust for you, and you are no longer the owner. As a result, the revenues are not included in your estate.

Why should you select trust ownership over transferring ownership to another person? One argument may be that you still want legal control over the policy. Perhaps you are concerned that an individual owner will fail to pay premiums, but the trust would guarantee that all premiums are paid on time. If the profits’ beneficiaries are minor children from a previous marriage, an ILIT allows you to choose a trusted family member as trustee to manage the funds for the children in accordance with the requirements of the trust instrument.

Advisor Insight

AEPSquam Lakes Financial Advisors, LLC, Holderness, NH, Robert E. Maloney

An “apportionment provision” in a will might result in tax obligations for the recipient. The provision may stipulate, for example, that any estate taxes owed will be paid proportionately by the beneficiaries who inherit the benefactor’s assets.

There would be an estate tax owed in this case, but no income tax. When the life insurance company pays out the policy proceeds to the beneficiary over a long period of time, some income tax may be required.

The face value of the insurance, on the other hand, is tax-free. The legislation also mandates the insurance company to pay the beneficiary interest from the date of death until the funds are paid out.

Regulations on Life Insurance Policy Ownership

When an insured individual dies, the IRS has devised guidelines to assist identify who owns a life insurance policy. The three-year rule, which specifies that any gifts of life insurance policies made within three years after death are still liable to federal inheritance tax, is the fundamental regulation supervising rightful ownership. This applies to both the transfer of ownership to another person and the formation of an ILIT.

  Inheritance Tax: What It Is, How It's Calculated, Who Pays It

The IRS will also investigate any instances of ownership by the individual transferring the insurance. The original owner must give up all legal rights to alter beneficiaries, borrow against the insurance, surrender, cancel the policy, or choose beneficiary payment choices when transferring the policy.

Furthermore, in order to retain the insurance in place, the original owner must not pay the payments. These activities are regarded part of the ownership of the assets, and if any of them are carried out, the tax benefit of transferring them may be lost.

Even if a policy transfer satisfies all of the conditions, part of the transferred assets may still be taxed. If the current cash value of the insurance exceeds the gift tax exclusion of $15,000 in 2021 and $16,000 in 2022, gift taxes will be charged and payable when the original policyholder dies.

Do You Have to Pay Taxes on Money Received as a Beneficiary?

Normally, you do not have to pay taxes on life insurance proceeds received as a beneficiary.

Do You Pay Taxes on Inherited Life Insurance Money?

No. Unless the life insurance benefit earned interest, you do not have to pay taxes on inherited life insurance money. If this occurs, you may be required to pay interest taxes.

How Do I Avoid Taxes on Life Insurance Proceeds?

Normally, life insurance profits are not subject to estate or income tax.

Do I Need to Report Inheritance to the IRS?

Most inheritance does not need to be reported to the IRS.

The Bottom Line

Individuals are often protected under a life insurance policy for amounts ranging from $500,000 to several million dollars in death payments. When you include in the worth of your house, retirement accounts, savings, and other possessions, the amount of your estate may surprise you. If additional years of growth are considered, certain people may face an estate tax problem.

One conceivable strategy is to maximize your giving potential and transfer insurance ownership whenever possible at a low or no gift-tax expense. Your estate might save a large amount of tax if you survive for another three years following the transfer.

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