Understanding Inheritance: Gifts, Life Insurance, And More

Life insurance is a financial safety net that ensures your loved ones are cared for in your absence. While it's not the most glamorous of gifts, it can be a valuable present that maintains financial security for your family if the worst happens. You can give life insurance as a gift in a few different ways: by designating the recipient as the beneficiary or owner of your policy, or by buying a new policy for them.

If you designate the recipient as the beneficiary of your policy, they will receive the death benefit upon your death, usually as a tax-free, lump-sum payment. You can also transfer the ownership of your policy to the recipient, giving them the ability to make policy changes and name beneficiaries. Alternatively, you can buy a new policy for someone else, which guarantees their insurability and provides protection against the unknown.

In all cases, you will need to demonstrate an insurable interest in the person covered and ensure that the policy remains active by continuing to pay the premiums.

Life insurance death benefits are usually tax-free for beneficiaries

Lump Sum vs. Installments

If the beneficiary receives the death benefit as a lump sum, it is typically tax-free. However, if they choose to receive it in multiple payments or installments, it may be subject to taxes. This is because the payments include both the proceeds and the interest accrued, and the interest is taxable.

Interest Accumulation

If there is a delay in the benefit payout and the money is held by the life insurance company for a period, the beneficiary will have to pay taxes on the interest generated during that time. Even though the principal death benefit amount is not taxed, any interest earnings are taxable.

Estate Taxes

If the insurance policy's death benefit is paid to an estate and exceeds certain threshold limits, it may be subject to state and federal estate taxes. In the United States, the federal exemption amount for individuals was $13.61 million in 2024, while the exemption amount for married couples was $27.22 million.

Policy Owner, Insured, and Beneficiary Alignment

In some cases, the policy owner, the insured, and the beneficiary may be different people. If the policy owner is different from the insured, the payout to the beneficiary may be considered a taxable gift. For example, if a husband buys a life insurance policy for his wife and names their son as the beneficiary, the IRS may consider the payout a taxable gift from the husband to the son if the wife passes away.

To avoid unintended tax consequences, it is important for individuals to carefully consider their life insurance policies and seek guidance from experienced financial professionals.

Beneficiaries may owe taxes if they earn interest on the insurance death benefit

Life insurance is often used as a way to leave an inheritance for loved ones after you pass away. The life insurance death benefit is usually paid directly to the beneficiaries and is typically tax-free. However, there are certain circumstances where beneficiaries may owe taxes on the insurance death benefit. One such scenario is when beneficiaries earn interest on the death benefit.

When beneficiaries receive the death benefit as a lump sum, they can avoid paying taxes on it. However, some beneficiaries opt to receive the benefit in installments, which can accrue interest over time. In such cases, the beneficiary is required to pay taxes on the interest earned, even though the principal death benefit amount itself is not taxed. This interest income is typically reported on the beneficiary's annual income tax return, using forms like Form 1099-R or 1099-INT.

It is important for beneficiaries to understand the tax implications of their inheritance. While the death benefit itself is generally not taxable, any interest earned on that benefit is subject to taxation. This can occur when the benefit is held by the insurer and earns interest before being paid out to the beneficiary. Therefore, it is advisable for beneficiaries to consult with a qualified tax professional or financial planner to understand their tax obligations and make informed decisions regarding their inheritance.

Additionally, it is worth noting that if the insurance death benefit is paid to an estate rather than directly to a beneficiary, it may be subject to different tax considerations, including estate taxes if the value exceeds certain thresholds.

The death benefit may be taxed if it is paid to an estate that exceeds threshold limits

The death benefit is generally not subject to income tax and is paid directly to the beneficiaries. However, if the death benefit is paid to an estate and exceeds the tax exemption amount, it may be subject to state and federal estate taxes. The federal estate tax limit for individuals was $13.61 million in 2024. This limit is periodically adjusted for inflation.

If the death benefit is paid to an estate, it is crucial to monitor the estate's size to ensure it stays within exemption limits. Exceeding these limits may result in unintended tax consequences for beneficiaries. To avoid this, it is advisable to name direct beneficiaries instead of the estate. Additionally, consider using an irrevocable life insurance trust, which can help keep the proceeds outside of the estate, thereby avoiding estate taxes.

It is important to note that the information provided here is for educational purposes only and should not be considered tax advice. For specific guidance on your situation, consult a qualified tax professional.

The payout may be considered a taxable gift if the policyholder, insured and beneficiary are different people

When it comes to life insurance, the death benefit is typically paid directly to the policy's beneficiaries and is tax-free. However, in certain situations, the payout may be considered a taxable gift. This occurs when the policy owner, the insured, and the beneficiary are different people, a scenario known as the "Goodman Triangle."

In this case, if the insured passes away, the IRS considers the payout a taxable gift from the policyholder to the beneficiary. For example, if John buys a life insurance policy for his wife, Sherry, and names their son, Luke, as the beneficiary, the payout to Luke upon Sherry's death would be considered a taxable gift from John. Consequently, John may have to pay gift taxes if the amount exceeds the federal gift tax exemption limits, and he must file IRS Form 709 by the following year's tax filing deadline.

To avoid such scenarios, it is essential to ensure that the policy owner and the insured are the same person or that the policy owner and beneficiary are the same. This alignment prevents the payout from being treated as a taxable gift.

Additionally, it is worth noting that beneficiaries can avoid paying taxes by receiving the death benefit as a lump sum instead of converting it into a payment stream, as interest accrued on the distribution is taxable.

Life insurance can be given as a gift by designating the recipient as the owner or beneficiary of an existing policy or by establishing a new policy for them

Life insurance can be a valuable gift to a loved one, providing financial security in the event of the policyholder's death. While most people buy life insurance for themselves, it is possible to give it as a gift by either designating the recipient as the owner or beneficiary of an existing policy or by establishing a new policy for them.

Designating the Recipient as a Beneficiary

If you wish, you can name your intended recipient as a beneficiary of your life insurance while remaining the owner of the policy. This means that the beneficiary will receive the death benefit upon your death, typically as a lump-sum payment, without having to worry about paying taxes on it. You retain control of the policy and can make changes if needed, such as naming a different beneficiary or multiple beneficiaries.

Transferring Ownership of Your Policy

Transferring ownership of your policy to the recipient is a more involved option. In this case, the recipient becomes the owner of the policy and can make changes, name beneficiaries, etc. You may be able to continue paying the premiums on the policy as a gift, but it's important to check with your insurance provider to avoid signing up the recipient for payments unintentionally. Gifting the ownership of your policy may also provide tax benefits, especially if the recipient is a charity.

Buying a New Policy as a Gift

Another way to give the gift of life insurance is to purchase a new policy for someone else, which is an excellent option for young relatives who may not otherwise have coverage. When establishing a new policy, you'll need to provide proof of insurable interest, the recipient's consent and personal information, and potentially a medical exam. By buying a new policy, you can guarantee the recipient's insurability and protect them against unknown future health issues. Additionally, some life insurance policies provide financial support beyond death benefits, such as a cash value component for retirement income.

Important Considerations

When giving life insurance as a gift, it's crucial to understand the tax implications. While life insurance death benefits are typically tax-free, improper structuring can result in unexpected taxes for beneficiaries. For example, if the beneficiary chooses to receive the death benefit in installments and earns interest on the distribution, they may owe income taxes on that interest. Additionally, if the insurance policy's death benefit exceeds the tax exemption amount and is paid to an estate, it may be subject to state and federal estate taxes.

To avoid these issues, it's recommended to name direct beneficiaries instead of your estate and consider using an irrevocable life insurance trust (ILIT). By doing so, you can prevent the death benefit from being included in your estate, reducing potential taxes. Additionally, monitor your estate size to stay within exemption limits, and ensure that the policy owner, insured, and beneficiary are correctly aligned to prevent the payout from being considered a taxable gift.

Frequently asked questions