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Does Life Insurance Inheritance Tax Apply to Your Benefits?
You might think that inheritance taxes apply only to property, heirlooms, and other assets. But, life insurance inheritance tax applies to many policies and many estates of a certain size and structure.
Knowing when tax rules may apply to your estate or final gift will help you structure your policy and payouts.
Many people pay taxes on the proceeds of death benefits each year because the IRS and state tax authorities levy a percentage against all kinds of “unearned income.”
This is especially true when death benefit profits come from an estate of great size. Otherwise, they apply based on the beneficiary relationship and the death benefit type.
In many cases, there are ways to avoid these steep taxes, but you have to know what you’re looking for when it comes to federal and state tax regulations.
See whether taxes will apply to your death benefits by considering the following categories and sections:
- Estate Value
- State Policy
- Beneficiary Relationship
- Indirect Benefits
- Income-Generating Proceeds
Once you understand these different tax situations, you’ll be able to structure a tax-free life insurance policy that avoids unnecessary losses.
Estate Value
Estates of considerable size often endure life insurance inheritance tax, but it applies to only the largest estates.
When the combined assets are assessed at more than $11.7 million, the IRS will apply estate tax, and they could take a large portion of life insurance benefits.
(In 2018 alone, the IRS earned $17 billion from estate tax according to Statista.)
States can also tack on an additional taxation percentage based on their own requirements for residents and beneficiaries in their jurisdiction.
State Policy
Twelve states have decided to tax residents with inheritance tax, but it doesn’t always apply to an estate or a life insurance death benefit.
Heirs and current estates should concern themselves with the possibility of taxes on the inheritance and, in effect, death benefit proceeds.
The following states impose taxes on estates:
- Connecticut
- District of Columbia
- Illinois
- Maine
- Maryland
- Massachusetts
- New York
- Rhode Island
- Vermont
- Washington
Other states tax inheritances only, but each has its own rules about which estates or inheritances taxes apply to and by what percentage they will get taxed.
Refer to Sproutt’s article on life insurance inheritance taxes to learn more about these state regulations.
Beneficiary Relationship
Luckily, spouses never endure state taxes on what they inherit, meaning that insurance benefits which are considered an inheritance won’t pay the high percentage.
Additionally, children—and even grandchildren—can’t be taxed in most states with inheritance tax policies (with the exception of Pennsylvania and Nebraska).
In some states, you can expect taxes when giving to an extended relative like a nephew or niece, but, for the most part, inheritances to those who are not part of the benefactor’s family are taxed at the highest possible level.
Indirect Benefits
When death benefits are given directly to family or beneficiaries, the proceeds are never taxed federally. But, you can introduce tax rates when the profits are dispersed to an estate.
This is the case when the beneficiary dies closely after the insured before the benefits can be properly claimed.
More than this, even selecting a secondary beneficiary means that death benefits go into an estate since the primary beneficiary still has the “first right” to the proceeds.
This can be unpleasant for people with estates over $11.7 million and those who live in states with lower tax thresholds.
Income-Generating Proceeds
One of the most common ways that individuals get taxed on death benefits is through using the proceeds to generate income and not claiming them immediately and directly.
When the insurance income gets invested or generates interest, it introduces taxation in the structure of the asset and the type of income it’s categorized as.
When a beneficiary creates income from an investment—which is how the IRS views death benefits that garner interest—they are taxed because all forms of interest are taxable under federal law.
There is simply no avoiding this policy when beneficiaries choose to multiply the death benefits through investment-like installment payments.
Any amount grown from the original death benefit amount becomes taxable. Policies intended to multiply the income for beneficiaries should consider this kind of tax before deciding how benefits will finally be dispersed.
Cut Out Taxes with Life Insurance from Sproutt
Knowing how to structure your life insurance policy and determining the smartest way to dole out death benefits can help your beneficiaries avoid losing benefits to taxation.
One of the simplest ways is to simply give to your beneficiaries directly without planning to stagger payments and create interest.
An attorney and advisor can help you design a tax-free estate and trust. But, many people can get by with a traditional life insurance policy with brokers like Sproutt.
Protect your legacy, give to your loved ones, and avoid taxes with a well-structured life by getting a life insurance policy quote from Sproutt.
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