Understanding Non-Qualified Inherited Life Insurance Policies

Life insurance is a way to provide financial security for loved ones after your death. It can be used to cover funeral costs, pay off debts, and manage money over a longer period. When a person with life insurance dies, the money from the life insurance death benefit is paid out to the primary beneficiary or beneficiaries. If there are no primary beneficiaries, the money is paid to a contingent beneficiary. The process of inheriting money can be lengthy and complicated, especially when multiple beneficiaries are involved.

In the United States, life insurance proceeds that beneficiaries receive due to the death of the insured person are generally not considered taxable income and do not need to be reported. However, any interest earned on the principal amount is taxable and must be reported. Additionally, if the policy was transferred for cash or other valuable consideration, the exclusion for proceeds is limited to the sum of the consideration paid, additional premiums paid, and certain other amounts.

Life insurance policies can be Qualified or Non-Qualified plans for tax purposes. A qualified retirement plan is an employer's plan that meets specific Internal Revenue Code requirements and may qualify for special tax benefits, such as tax deferral for employer contributions. Examples include 401(k) plans and IRA plans. On the other hand, non-qualified plans are not eligible for tax-deferral benefits, and public sector plans fall under this category. If it is not an employer plan, it is typically considered a non-qualified plan.

Life insurance beneficiaries and taxes

Life insurance beneficiaries generally do not pay taxes on the proceeds of the policy. However, there are some exceptions.

When beneficiaries may have to pay taxes on life insurance

• The policy accrued interest: If the life insurance proceeds have accumulated interest, taxes are usually due on the interest, rather than the entire death benefit.
• The policyholder names their estate as a beneficiary: If the policyholder chooses their estate as a life insurance beneficiary, taxes might apply depending on the estate's value.
• The insured and the policy owner are different: If a different person holds each role, there may be taxes involved.

Ways to avoid paying taxes on a life insurance payout

• Use an ownership transfer: Transfer ownership of the policy to another person or entity to avoid taxation.
• Create an irrevocable life insurance trust (ILIT): An ILIT owns the life insurance policy, meaning the proceeds will not be included in your estate.
• Keep the cash value below the gift tax exemption: A 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.

Other tax considerations for life insurance beneficiaries

While the death benefit is usually not taxed, beneficiaries are still subject to tax on earnings from their inheritance. For example, if the payout is set up to be paid in multiple payments, the payments may include proceeds and interest, which can be subject to taxes. Additionally, if the deceased lived in a state that levies inheritance tax, the beneficiary may be required to pay tax on the money they inherit.

Distribution options for life insurance proceeds

Life insurance proceeds can be distributed in a few ways. Beneficiaries can opt to receive a lump-sum payout or establish an annuity, which provides installment payments over several years. For minors and beneficiaries with special needs, it is important to seek advice from a financial advisor or legal expert to ensure that all paperwork is filled out correctly and that funds are distributed in accordance with any state laws or trust documents.

Life insurance death benefit

A death benefit is the money paid out to beneficiaries following the death of the insured person during the policy's term. This is the primary purpose of life insurance and how policies are described. For example, a $100,000 policy means there is $100,000 worth of death benefit insurance.

The death benefit is typically paid as a lump sum, but beneficiaries can also opt for annuity payments. The death benefit is usually tax-free, but there may be tax owed on any interest accrued.

The policyholder chooses the beneficiaries, who are most commonly the spouse, children, or other close family members. However, any person, charity, or organisation can be named as a beneficiary. The policyholder can also specify how much of the death benefit each beneficiary will receive.

Beneficiaries must submit proof of death and proof that they are the intended recipient of the benefit. This usually means providing a certified copy of the death certificate and a copy of the policy.

There are several types of death benefit:

• All-cause death benefit: The policy will pay out regardless of the cause of death, except in rare cases where the cause is specifically excluded by the policy.
• Accidental death benefit: This type of policy only pays out if the death is the result of an accident, such as a car crash or drowning.
• Accidental death and dismemberment: This type of policy pays out for deaths resulting from accidents and also covers accidents that cause major injuries such as the loss of a limb, paralysis, or blindness.

Non-qualified plans

There are four major types of non-qualified plans:

• Deferred compensation plans
• Executive bonus plans
• Split-dollar life insurance plans
• Group carve-out plans

Contributions to these plans are usually non-deductible for the employer and taxable for the employee. However, they allow employees to defer taxes until retirement, when they will presumably be in a lower tax bracket.

One type of non-qualified plan is the Executive Bonus Plan, which allows a business to provide personally owned life insurance as a tax-deductible fringe benefit to select key employees. The employer decides who participates and how much of a bonus each employee will receive. Bonus dollars are tax-deductible to the company as compensation to the key employee. The key employee will own and control the policy and will have access to the riders, potential cash value growth, and death benefit that make up the permanent life insurance policy.

Qualified plans

A qualified retirement plan is an employer's plan that benefits employees and meets specific Internal Revenue Code requirements. These plans may qualify for special tax benefits, such as tax deferral for employer contributions. Your contributions may also qualify for tax deferral. Examples of qualified plans include 401(k) plans and IRA plans.

It is possible to buy life insurance through some qualified retirement plans, like a 401(k) or a pension. If you do so, you can pay for the coverage using pre-tax dollars. In other words, you save on taxes while buying life insurance.

• The ability to use pre-tax dollars to pay premiums that would otherwise not be tax-deductible.
• The option to pay for the insurance using your existing retirement plan savings.
• Fully funding your retirement benefit if you die while working.
• Providing an income-tax-free death benefit to your policy beneficiaries.
• Asset protection, as an Employee Retirement Income Security Act (ERISA) plan is generally protected from creditors.

However, there are also some disadvantages to consider:

• The life insurance policy can only be held in the plan while you are a participant.
• It can be complex to unwind the insurance when you retire or if the plan is terminated.
• The organization sponsoring the plan needs to offer a qualified plan that allows for life insurance. These plans tend to be costly to set up and require annual reporting and ongoing administration. Lower-cost retirement plans, like an IRA or a simplified employee pension, do not allow life insurance.
• Plans must abide by ERISA rules that require all eligible employees to be included. The plan cannot discriminate in favor of certain participants, such as only offering benefits to the business owner and key executives.

If you're considering buying life insurance through a qualified retirement plan, it's important to consult with an insurance and a retirement plan expert to ensure you understand the strict rules and complexities involved.

Tax implications of inherited annuities

The tax implications of inheriting an annuity can be complex and depend on several factors, including the type of annuity, the beneficiary's tax status, and the chosen payout method. Here's what you need to know:

Qualified vs. Non-Qualified Annuities:

• Qualified annuities are purchased with pre-tax dollars within tax-advantaged retirement accounts, such as IRAs or 401(k)s.
• Non-qualified annuities are purchased with after-tax dollars.

Tax Implications for Beneficiaries:

• For non-qualified annuities, beneficiaries generally don't owe taxes on the original contributions but will pay ordinary income tax on any accumulated earnings distributed.
• For qualified annuities, beneficiaries will owe ordinary income tax on the entire amount withdrawn, including both the initial investment and any earnings.
• Spouses who inherit qualified annuities can usually roll the funds into their own IRA and defer taxes on future withdrawals.

Payout Options and Tax Consequences:

• Lump-sum payouts: The entire taxable portion of the payout is included in the beneficiary's income in the year of distribution, potentially pushing them into a higher tax bracket.
• Payment streams: The tax liability is spread over multiple years, with each payment from a non-qualified annuity including a taxable portion of the gain and a non-taxable portion of the original contribution. For qualified annuities, the entire payment is taxable.
• Non-qualified stretch provision: This option allows beneficiaries to stretch payments over their life expectancy, further reducing the tax burden.
• Qualified distribution rules: For qualified annuities, most beneficiaries must deplete the account within 10 years of the owner's death, with some exceptions for spouses and certain other beneficiaries.

Additional Considerations:

• It's important to review the annuity contract, as it will outline the specific details, beneficiary information, and available payout options.
• Understanding the different death benefit options and seeking guidance from a financial advisor can help maximize the benefit of your inheritance.
• Inherited annuities can be a complex but financially beneficial experience, and careful consideration of tax implications is essential to making informed decisions.

Frequently asked questions