Taxes Due On Life Insurance Inheritance From A Parent?

Life insurance payouts are generally not taxable, but there are some instances where beneficiaries may be taxed. For example, if the beneficiary is not a person but an estate, the estate may be taxed. In this case, the estate is responsible for paying federal taxes such as federal estate and gift tax, and generation-skipping transfer tax. Additionally, some states impose inheritance and estate taxes. Another instance where beneficiaries may be taxed is when the cash value of the policy exceeds a certain amount, leading to estate tax or generation-skipping tax. It is important to consult with a tax professional to understand the specific tax implications for your situation.

Are life insurance proceeds taxable income?

Life insurance proceeds are generally not taxable, but there are some instances where beneficiaries may be taxed on their inheritance.

Inheritance Tax

If you are a beneficiary, in most cases, you do not have to pay taxes on the proceeds of a life insurance policy. Proceeds are typically paid out tax-free, but there are some exceptions. For example, if you live in Iowa, Kentucky, Nebraska, New Jersey, Maryland, or Pennsylvania, an inheritance tax is enforced.

Estate Tax

If the beneficiary is not named in the policy, the proceeds will go to the estate. The first $11.7 million is not taxed at the federal level, but anything above this amount is subject to federal estate tax. There is also a chance that state taxes will be applied, and these vary depending on location.

Generation-Skipping Tax

If the life insurance payout skips a generation, it may be taxed, but only if it exceeds the federal estate tax threshold.

Income Tax

Typically, life insurance proceeds are not considered taxable income. However, if the payout is set up to be paid in multiple payments, these payments may be subject to income tax. For example, an annuity that is paid regularly over the life of the beneficiary includes proceeds and interest, which can be taxed.

If the policyholder has withdrawn money or taken out a loan against the policy, and the amount withdrawn is more than the total amount of premiums paid, the excess may be taxable.

Surrendering Your Policy

If you surrender your life insurance policy, the amount you paid into it will be returned to you tax-free. However, any funds over the policy's cash basis will be taxed as regular income.

Employer-Paid Group Life Plan

If you are a beneficiary of an employer-paid group life plan, the death benefit is usually paid out tax-free. However, if the payout is over $50,000, it may be taxed according to the Internal Revenue Service (IRS).

Disputes

If there is a dispute over who should receive the proceeds, the case may go to probate court for resolution. This process can be lengthy and costly, so it is important to seek legal advice.

What is an estate tax?

An estate tax is a tax on your right to transfer property at your death. It is an accounting of everything you own or have certain interests in at the date of death. The fair market value of these items is used, not necessarily what you paid for them or what their values were when you acquired them. The total of all of these items is your "Gross Estate".

The Gross Estate includes cash and securities, real estate, insurance, trusts, annuities, business interests, and other assets. Once you have accounted for the Gross Estate, certain deductions (and in special circumstances, reductions to value) are allowed in arriving at your "Taxable Estate". These deductions may include mortgages and other debts, estate administration expenses, property that passes to surviving spouses, and qualified charities.

The estate tax is assessed on the estate's fair market value (FMV), not on the price the deceased paid. This means any appreciation in the estate's assets over time will be taxed, but it protects those who inherit assets that have dropped in value. For example, if a house was bought for $5 million, but its current market value is $4 million, the latter amount will be used for tax purposes.

The federal estate tax as of the 2024 tax year applies only to the value of an estate that exceeds $13.61 million. In 2025, the exemption rises to $13.66 million. Surviving spouses are generally exempt from these taxes, regardless of the value of the estate or inheritance.

A dozen states impose their own estate taxes, and six have inheritance taxes, both of which kick in at lower thresholds than the federal estate tax. The lowest thresholds are $1 million, and the highest estate tax rates are 18%.

What is an inheritance tax?

An inheritance tax is a levy imposed by some states on the beneficiaries of an inheritance. This is distinct from an estate tax, which is assessed on the estate itself before its assets are distributed. There is no federal inheritance tax in the US, but six states collected inheritance taxes as of 2024: Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania. Iowa will phase out its inheritance tax by 2025.

The taxation of an inheritance depends on the state in which the deceased lived or owned property, the value of the inheritance, and the beneficiary's relationship to the decedent. Typically, your inheritance must be greater than a certain minimum amount for you to owe taxes on it. Surviving spouses are exempt from inheritance tax in all six states that impose it.

The inheritance tax is a tax on the right to receive property by inheritance. It is levied on the value of the inheritance received by the beneficiary, and it is paid by the beneficiary.

What is a generation-skipping tax?

The generation-skipping transfer tax (GSTT) is a federal tax on transfers of assets or property to individuals who are more than one generation below the transferor. This includes transfers from a grandparent to a grandchild or to individuals who are more than 37.5 years younger than the transferor (the "skip" generation). The GSTT was introduced in 1976 to prevent wealthy families from avoiding estate taxes at the death of each generation.

The GSTT is equal to the highest federal gift and estate tax rate at the time of the transfer (40% in 2024) and is in addition to any other federal gift or estate tax that may be owed. The tax is imposed on three types of taxable events: direct skips, taxable distributions, and taxable terminations. Direct skips occur when assets are transferred from one individual to a skip person, either outright or in trust. The transferor or their estate is responsible for paying the GST tax for direct skips. Taxable distributions occur when a distribution of income or principal is made by a trust to a skip person, and taxable terminations occur when an interest in property held in trust terminates, with no other non-skip beneficiaries, and the trust assets are not included in the deceased, non-skip beneficiary's estate.

The GSTT exemption is very high, and most beneficiaries will avoid the tax because the estates they inherit will be worth less than the government-provided estate tax credit. For 2024, the federal estate, gift, and GSTT exemption is $13.61 million for each individual ($13.99 million in 2025) and $27.22 million for married couples ($27.98 million in 2025). Only the value of a person's estate that is in excess of the applicable exemption is subject to the GSTT.

There are ways to reduce the GSTT, such as by using dynasty trusts or making contributions to 529 plans. Dynasty trusts are irrevocable trusts that incorporate asset protection provisions and generation-skipping transfer tax strategies, and they can be designed to last indefinitely. Contributions to 529-qualified tuition programs for the benefit of grandchildren (or other skip individuals) are considered completed gifts, even if the transferor has the right to change the beneficiary at their discretion.

How do you avoid taxes on life insurance proceeds?

Life insurance payouts are usually not taxable, but there are some exceptions. Here are some ways to avoid paying taxes on life insurance proceeds:

Ownership Transfer

If an estate is involved, whether life insurance proceeds are taxable is based on the policy's ownership when the insured passes away. To avoid taxation, you can transfer ownership of your policy to another person or entity. Here are some guidelines to follow:

• Choose a competent adult or entity to be the new owner (it can be the policy beneficiary).
• Obtain the proper assignment or transfer of ownership forms from your insurance company.
• New owners must pay the premiums on the policy. You can gift a certain amount per person per year to help cover these costs.
• Keep in mind that you will give up all rights to make changes to the policy in the future.
• Obtain written confirmation from your insurance company as proof of the ownership change.

Create an Irrevocable Life Insurance Trust (ILIT)

Another way to avoid taxes on life insurance proceeds is to create an ILIT. With this option, you will no longer be considered the owner of the policy, and the proceeds will not be included in your estate. Here are some things to keep in mind:

• You cannot be the trustee of the trust, and you cannot retain any rights to revoke the trust.
• You may want to choose this option if you wish to maintain some legal control over the policy or ensure that premiums are paid promptly.
• If the beneficiaries are minor children from a previous marriage, an ILIT allows you to name a trusted family member as trustee to handle the money according to the trust document.

Additional Considerations

• Be aware of the three-year rule: any gifts of life insurance policies made within three years of death are still subject to federal estate tax.
• Consult with a tax professional to ensure you are taking the appropriate steps to avoid taxation and to lower your tax liability.
• Avoid naming your estate as the beneficiary, as this can increase the value of your estate and subject your heirs to high estate taxes.
• If you live in a state with inheritance tax (Iowa, Kentucky, Nebraska, New Jersey, Maryland, and Pennsylvania), be sure to understand the guidelines regarding taxes on life insurance policies.

Frequently asked questions