Understanding Tax Implications Of Beneficiary Life Insurance In New Mexico

If you're a beneficiary of a life insurance policy, you may be wondering if you'll need to pay taxes on the money you receive. This paragraph will explore the tax implications for beneficiaries of life insurance policies and provide an overview of when taxes may or may not be owed. In most cases, beneficiaries do not have to pay taxes on their life insurance payouts, as the proceeds are generally not considered taxable income. However, there are some exceptions to this rule, and understanding these exceptions can help beneficiaries make informed decisions about their financial planning.

Life insurance payouts are usually tax-free

If you are a beneficiary of a life insurance policy, the money you receive from the policyholder's death benefit is generally not considered taxable income. This means that the payout is not subject to income tax and does not need to be reported to the IRS.

However, there are a few instances where the money may be taxed:

• Interest accrued on the benefit: If the benefit has accumulated interest, the beneficiary will need to pay taxes on the interest earned. This is because income earned in the form of interest is usually taxable.
• Beneficiary is the insured's estate: If the policyholder names their estate as the beneficiary, the money paid to the estate could be subject to estate taxes. This is because the insurance policy increases the value of the estate, and if the estate is large enough, the benefits may fall under the estate tax. In 2024, estates over $13.61 million owed estate tax.
• Owner and insured are different people: If the owner of the policy is not the same as the insured person, the payout to the beneficiary could be considered a taxable gift.

To avoid paying taxes on a life insurance payout, there are a few strategies that can be considered:

• Transfer policy ownership: The policy's ownership can be transferred to another person or entity. However, note that if the transfer occurs within three years of the previous owner's death, the IRS will treat it as if the previous owner still held the policy.
• Create an irrevocable life insurance trust (ILIT): By transferring ownership of the policy to an ILIT, it is removed from the owner's estate, and the proceeds will not be included in their estate. The owner can state how they would like the beneficiaries to receive or use the payout, but this type of trust cannot be revoked after it is set up.
• Be aware of gift tax limits: The annual gift tax exemption and lifetime exclusion amounts should be considered. In 2024, the annual gift tax exemption was $18,000, and the lifetime exclusion amount was $13.61 million. Keeping the policy's cash value below these limits may help avoid taxation.

Interest accrued on a policy is taxable

Life insurance payouts are usually not taxable. However, there are some exceptions. One of these is when the policy has accrued interest.

Interest accrued on a life insurance policy is generally taxable. This is the case whether the beneficiary receives the proceeds as a lump sum or in periodic payments. The interest is reported to the Internal Revenue Service (IRS) by the insurance company, and the beneficiary must pay taxes on it. This is separate from the death benefit, which is usually not taxed.

If a beneficiary chooses to receive periodic payments over a number of years, the insurance company will typically pay interest on the remaining balance. The tax code treats these payments similarly to annuities. Each payment consists of a portion of the death benefit and a portion of interest, and the interest is taxed.

For example, if a beneficiary chooses to receive $2,200 per month for 10 years from a $250,000 policy, $110 of the monthly payment will be taxable interest. This is because $250,000 divided by the total payout of $264,000 equals 95%, so 5% of the $2,200 payment is interest.

If a beneficiary chooses to leave the payout on deposit with the insurance company, earning interest, they must still report the interest as income in the year that they earn it. The insurance company will send the beneficiary a Form 1099 each year, reporting how much interest was earned.

Naming an estate as beneficiary may incur taxes

Naming an estate as the beneficiary of a life insurance policy is generally a poor choice in terms of tax implications. While life insurance payouts are usually not taxed as income, there are exceptions to this rule. One such exception is when the beneficiary is an estate rather than an individual. In this case, the person or people inheriting the estate may have to pay estate taxes.

Estate taxes vary depending on the location and the value of the estate. In some places, the first $50,000 of an estate's value is exempt from taxes, with the remainder taxed at a rate of 1.5%. In other cases, a basic exclusion amount is set for estates, such as $12.06 million for a decedent who passed away in 2022, and $12.92 million for 2023. If the value of an estate exceeds these thresholds, it may be subject to taxation.

It is important to note that the tax implications of naming an estate as a beneficiary are not limited to estate taxes. When an estate is named as a beneficiary, the financial product becomes subject to the probate process. This can result in additional fees, risks, and exposure to creditors. The probate process can also be costly and time-consuming, impacting the speed at which beneficiaries receive their inheritance.

To avoid these potential issues, it is generally recommended to name specific individuals, such as a spouse, adult children, or a trust, as beneficiaries of a life insurance policy. By doing so, the inherited funds can pass directly to the beneficiary without going through the probate process, providing a more favourable tax outcome.

In summary, naming an estate as a beneficiary of a life insurance policy can incur taxes and other financial implications. It is important for individuals to carefully consider their options and seek professional advice to ensure their choices align with their intentions and minimize any potential tax burden on their beneficiaries.

Insured and policy owner being different people may cause taxes

In most cases, beneficiaries do not need to pay taxes on their life insurance payout. However, there are exceptions. One such exception is when the insured and the policy owner are different people. In this case, the IRS may conclude that the death benefit amount from the policy owner to the beneficiary is a taxable gift.

The person who buys a life insurance policy is usually considered the owner and insured. But if a different person holds each role, there may be taxes involved. The insured is the person whose life is insured, and they are usually the ones who pay the premium. The owner of the policy has control over the policy during the insured's lifetime and can surrender the policy, sell the policy, gift the policy, or change the policy death benefit beneficiary.

If the insured and the policy owner are different people, the IRS will treat the payout to the beneficiary as a taxable gift. This is because the owner is gifting the death benefit amount to the beneficiary. The gift tax comes into play if the life insurance policy's cash value is higher than the gift tax exemption, which is $12.92 million or $17,000 per year as of 2023.

To avoid paying taxes on a life insurance payout in this situation, you can transfer ownership of the policy to another person or entity. This strategy can help remove the proceeds from your taxable estate. However, it's important to note that the transfer must occur at least three years before your death for the policy to be excluded from your estate.

Another way to avoid taxation is to create an irrevocable life insurance trust (ILIT). With an ILIT, the trust owns the life insurance policy instead of the individual. This means that the proceeds are not included in the estate of the insured. It's important to note that an ILIT cannot be revoked once it's been set up.

Transferring ownership can avoid taxes

If you want to avoid your life insurance proceeds being subject to federal taxation, you can transfer ownership of your policy to another person or entity. This is because, whether or not life insurance proceeds are included as part of the taxable estate depends on the ownership of the policy at the time of the insured person's death.

There are a few key guidelines to remember when considering an ownership transfer:

• Choose a competent adult or entity to be the new owner. This could be the policy beneficiary. Then, call your insurance company for the proper assignment or transfer of ownership forms.
• New owners must pay the premiums on 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, they can make changes at your request.
• Obtain written confirmation from your insurance company as proof of the ownership change.

It's important to note that transferring ownership is an irrevocable event, so you should be cautious of divorce situations when planning to name the new owner. Additionally, if you die within three years of transferring ownership, the full amount of the proceeds will be included in your estate as though you still owned the policy.

Another way to remove life insurance proceeds from your taxable estate is to create an irrevocable life insurance trust (ILIT). In this case, you cannot be the trustee of the trust, and you may not retain any rights to revoke the trust. 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.

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