Life Insurance Proceeds: Maryland's Tax Laws Explained

Life insurance is a valuable tool for providing financial security for your loved ones after your death. However, it's important to understand the tax implications of life insurance proceeds to ensure your beneficiaries receive the full benefit. In the state of Maryland, life insurance proceeds are generally exempt from inheritance tax, but there are specific conditions that must be met to avoid taxation. This is particularly important as Maryland is one of the few states that collects both inheritance and estate taxes, which could significantly reduce the value of your beneficiaries' inheritance. So, are life insurance proceeds taxable in Maryland?

Life insurance proceeds are not taxable if they go to a named beneficiary

Life insurance proceeds are not subject to the Maryland inheritance tax if they go to a named beneficiary. This is because the proceeds are considered income-tax-free at the federal level. However, it is important to note that if the beneficiary is the estate of the insured, then the proceeds may be included in the taxable estate for estate tax purposes.

In Maryland, the inheritance tax is imposed on heirs when they receive assets from a deceased person's estate. The tax is based on the relationship between the beneficiary and the decedent, as well as the value of the inherited property. While Maryland collects both an inheritance tax and an estate tax, close relatives of the deceased person are exempt from paying the inheritance tax. This includes the deceased person's child, stepchild, former stepchild, grandchild, parent, stepparent, former stepparent, and spouse. Additionally, the surviving spouse of a deceased child or grandchild of the deceased person is also exempt.

To avoid having life insurance proceeds included in the taxable estate, it is important to name a specific beneficiary other than your estate. By naming an individual as the beneficiary, the funds pass directly to that person, bypassing the estate and the probate process. This helps to reduce the overall value of the estate, which can result in lower estate taxes.

It is worth noting that the federal government has an estate tax, which is a tax on the right to transfer property at death. However, most estates will not have to pay this tax as it only applies to estates with a value exceeding the lifetime exclusion amount, which is $12.06 million for the tax year 2022 and $12.92 million for 2023.

Life insurance proceeds can be taxable if they are part of the probate process

Life insurance proceeds are generally not taxable in Maryland. However, if the proceeds become part of the probate process, they may be subject to taxation. This typically happens when the beneficiary of the life insurance policy is named as the estate, rather than an individual. In such cases, the proceeds become part of the probate estate and can increase the estate's value, potentially subjecting heirs to higher estate taxes.

To avoid this, it is advisable to name an individual as the beneficiary of the life insurance policy. By doing so, the funds pass directly to that person, bypassing the estate and the probate process. This is a crucial consideration, especially in Maryland, as it is one of the few states that impose both an estate tax and an inheritance tax.

It is important to note that even if the life insurance proceeds are not subject to probate, they may still be included as part of the taxable estate for estate tax purposes at the federal level. According to Section 2042 of the Internal Revenue Code, the value of life insurance proceeds is included in the gross estate if the proceeds are payable to the estate or if the deceased had any ownership incidents in the policy at the time of death.

To avoid federal taxation, individuals can consider transferring ownership of their life insurance policy to another person or entity. This requires choosing a competent adult or entity as the new owner, obtaining the proper assignment or transfer of ownership forms from the insurance company, and giving up all rights to make future changes to the policy. Another option is to create an irrevocable life insurance trust (ILIT), where the policy is held in trust, and the proceeds are not included as part of the estate.

In summary, while life insurance proceeds are generally not taxable in Maryland, they can become taxable if they are part of the probate process due to the naming of the estate as the beneficiary. To avoid this, individuals should name an individual as the beneficiary and consider ownership transfer or the establishment of an ILIT to minimize potential tax liabilities for their heirs.

Life insurance proceeds can be taxable if they are included in the taxable estate

Life insurance proceeds are generally not taxable in Maryland. However, if the proceeds are included in the taxable estate, they may be subject to taxation. This typically occurs when the policy owner makes the estate the beneficiary of the life insurance policy. In such cases, the proceeds become part of the probate estate and can increase the estate's value, potentially subjecting heirs to higher estate taxes.

To avoid this, it is essential to name a specific individual as the beneficiary of your life insurance policy. By doing so, the funds pass directly to that person, bypassing the estate and the probate process. This is a crucial distinction, as the probate process can result in higher taxes for your heirs.

Additionally, it is important to note that the ownership of the policy matters. If you are the owner of the policy, you must relinquish control, including the right to change beneficiaries or use the policy as collateral for a loan. If you do not give up ownership, the Internal Revenue Service (IRS) may include the proceeds in your taxable estate, even if they don't require probate.

One way to avoid this issue is to transfer ownership of the life insurance policy to another person or entity. This can be done by choosing a competent adult or entity, such as an irrevocable life insurance trust (ILIT), as the new owner. However, it is important to remember that this is an irrevocable decision, and you will give up all rights to make changes to the policy in the future.

Another option is to create an ILIT and transfer ownership of the policy to the trust. In this case, you cannot be the trustee of the trust, and you must not retain any rights to revoke it. The policy will be held in trust, and you will no longer be considered the owner, thereby excluding the proceeds from your estate.

Life insurance proceeds can be taxable if the policy owner dies within three years of transferring ownership

Life insurance proceeds are generally not taxable in Maryland. However, if the policy owner dies within three years of transferring ownership, the proceeds may be subject to taxation.

The state of Maryland collects both an inheritance tax and an estate tax, which are often referred to as "death taxes". While close relatives of the deceased are exempt from paying inheritance tax, the estate tax applies to estates worth more than several million dollars.

To avoid taxation on life insurance proceeds, it is possible to transfer ownership of the policy to another person or entity. This strategy can help reduce the taxable value of the estate. However, the three-year rule applies to such transfers. This means that if the original owner dies within three years of transferring ownership of the life insurance policy, the proceeds will be included in their estate and taxed accordingly.

To ensure a smooth transfer of ownership, it is recommended to choose a competent adult or entity as the new owner, obtain the proper forms from the insurance company, and obtain written confirmation of the ownership change. It is important to note that the original owner will give up all rights to make changes to the policy, and the new owner will be responsible for paying the premiums.

Another option to avoid taxation is to create an irrevocable life insurance trust (ILIT). By transferring ownership of the policy to a trust, the original owner will no longer be considered the owner, and the proceeds will not be included in their estate. It is important to note that the grantor of the trust cannot be the trustee, and the trust must be created at least three years before the grantor's death to avoid taxation.

Life insurance proceeds are not taxable at a federal level

The exemption amount for federal estate tax is $12.06 million for the 2022 tax year and $12.92 million for the 2023 tax year. If your estate falls below these exemption amounts, your beneficiaries will not have to pay any federal estate taxes.

It's important to note that the rules for state-level inheritance and estate taxes may differ. Maryland, for example, imposes both an estate tax and an inheritance tax. However, life insurance proceeds that go to a named beneficiary, rather than the deceased person's estate, are exempt from the inheritance tax in Maryland.

To avoid federal taxation on life insurance proceeds, you can transfer ownership of your policy to another person or entity. This involves choosing a competent adult or entity as the new owner, obtaining the proper forms from your insurance company, and giving up all rights to make changes to the policy. Another option is to create an irrevocable life insurance trust (ILIT) to hold the policy, which allows you to maintain some legal control over it.

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