Is Life Insurance Taxable for the Beneficiaries?
If you or someone you know has had to deal with being a beneficiary of a life insurance policy, then you have probably heard the question "Is life insurance taxable?" You may have even asked yourself "Is life insurance taxable?"
Unfortunately, the answer to that question is slightly complicated. Before diving into the answer to the question "Is life insurance taxable?", it is important to first look at how taxes work in the first place.
How Taxes Work
There is a lot to how taxes work. Too much for me to go into here. In order to just give you a background, so that I could answer the question "Is life insurance taxable?", I will go over the basics: what types of taxes you have to pay in the US and how to manage your taxes.
Types of Taxes
The main types of taxes in the US are:
taxes on income
taxes on real property
taxes on goods and services (aka sales tax)
estate taxes
It is important to remember that there are both state and federal taxes, which does complicate things a bit. Especially since the state income tax, for example, is different for every single state. Some states do not even have a state income tax (I'm looking at you Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming).
Besides the differences per state, tax brackets only complicate things even more. While 11 states have a flat income tax rate, 33 states chose to have a progressive income tax rate, which means that your income tax rate is determined by your income and what tax bracket you are in. Federal taxes also use a tax bracket system, which is done to try to be more fair and equitable.
Managing Your Taxes
Because of the complexity in taxes that I mentioned above, it is a good idea to have some kind of tax management system. By utilizing tax experts and tax tools, you can have an easier time dealing with your taxes. While it is generally cheaper to deal with your taxes on your own - and there are certainly enough cheap or free opportunities out there (compare free tax software options), you do not have to do this alone.
If you do decide to take taxes on your own, then consider taking advantage of some of the tips for saving money on taxes, such as:
Tax insights
The more tax insights you gain and the more you understand about taxes, the more likely you are to take advantage of every possible opportunity available to you. If you don't know about something, of course, you can't reap the benefits from it.
Claim Your Dependents
If you have dependents, then make sure that you know and understand the rules to claiming a dependent on your taxes.
Timing
Just like most things in life, when it comes to your taxes, timing is everything. There are a couple of examples for this:
When it comes to deductions, it makes a big difference if you pay for it on or before December 31st or on or after January 1st. For instance, if you pay your January mortgage payment in December, then you could count that deduction for the current instead of the upcoming year.
Just file your taxes on time. You do not want to get caught in a situation where you are filing your taxes late. If you know that you will have trouble filing your taxes on time, then file a tax extension when you need more time.
Donate
A gift tax for a charitable donation is a great way to help not only yourself but also others. Whether you are donating clothes to the Salvation Army or money to an important cause or charity, you can make a difference in the world, while also earning yourself a deduction on your taxes.
So, Is Life Insurance Taxable for the Beneficiaries?
Don't worry, I didn't forget about the original question of "Is life insurance taxable?" Now that you have a foundational understanding of taxes, we can dig deeper and focus just on life insurance now.
Life Insurance vs. An Estate
Well, kind of. Before we can just focus on life insurance, we need to determine if your life insurance is a part of an estate or not. This will determine the answer to the question of "Is life insurance taxable?"
Life Insurance
Life insurance is basically a contract between you and an insurance company. This contract says that in exchange for your payments (called premiums) - which may be monthly, quarterly, semiannually, or annually, depending on your contract - the insurance will pay out a certain amount of money upon your death. This contract can of course be broken, just like other contracts. If you are shown to have committed fraud or suicide, then the contract may become invalid.
The two main types of life insurance that you can get are whole life insurance and term life insurance. Which option is better for you really depends on you and your situation. However, it is important to keep in mind that term life insurance is just that - insurance just covering a term. It is only permanent, and if you outlive the policy, you cannot get any cash value: that means you won't see any money, despite all of those payments you made. Because of this, it can be a gamble.
Everything you need to know about taxes in one place. visit the taxry shop.
But if you're looking for something cheaper and with more flexibility, then term life insurance may still be a good option for you.
In contrast to a life insurance policy, which requires you to create a contract and make payments, your estate is just what you already own during your life. Your estate is what you own during life and which gets passed on to your next of kin after your death.
While a similar premise (passing some money or property on after your passing), life insurance policies are treated quite differently. We will go through each aspect below, to explain what is taxed for beneficiaries.
Is Estate Taxed?
Yes. Your estate will be taxed. An estate consists of property, which includes real estate, cash and securities, trusts, annuities, insurance, business interests, and other such assets.
However, do not confuse estate tax with inheritance tax, which in the US refers to two vastly different things. Each country does this differently though, so if you are a beneficiary of someone in another country, then this may work a bit differently. Put simply, in the US:
2. Responsible for inheritance taxes: Beneficiaries of an estate
Be careful though, this also depends on the state you live in. Some states only have an estate tax, some states only have an inheritance tax, and some states have both estate and inheritance taxes. As of 2019, a total of 12 states and the District of Columbia have a state estate tax. Exemptions are included in each of these states, though it differs from state to state what these exemptions are.
There is a federal estate tax, but most simple estates do not require you to file an estate tax return. If the combined estate (all of the property mentioned above, including combined gross assets and prior taxable gifts) is worth less than $11,580,000 in 2020, then you will not have to worry about a federal estate tax. If you are unsure if the estate that you are a beneficiary of is exempt from a federal estate tax or not, then you should speak to a tax expert for assistance.
The inheritance tax is much less common than the estate tax. Only six states collect an inheritance tax: Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania - Maryland the only one of which collects both an estate tax and inheritance tax, and the federal government does not even collect an inheritance tax.
Transfers of property to surviving spouses are completely exempt from the inheritance tax though, in every single one of the six states with an inheritance tax. If you live in Iowa, Kentucky, Maryland, or New Jersey, then you are also exempt from the inheritance tax if you are the child or grandchild of the deceased.
However, if you live in Nebraska or Pennsylvania, then you will not be exempt from the inheritance tax if you are the child or grandchild of the deceased.
The inheritance tax is generally for distant heirs, including siblings, nieces and nephews, and friends. But don't despair yet: Most states also offer exemptions for inheritance taxes, so you may still be able to get out of it, unless the gifts are above a certain value. Be careful though, the inheritance tax rate typically increases as the degree of kinship decreases.
Is Life Insurance Taxed?
It depends. The IRS does not tax life insurance proceeds. In some cases, life insurance is part of an estate, and in this case, you may have to worry about taxes on life insurance.
You generally won't have to worry about the IRS taxing life insurance proceeds, unless you have specifically named your estate as the beneficiary of your life insurance policy. If one or more beneficiaries is named for a life insurance policy and if at least one of these beneficiaries survives the decedent, then the money given out for the life insurance policy upon the decedent's death will go straight to the beneficiaries, bypassing the estate entirely. In that case, the insurance policy proceeds are not required to pay off the decedent's final bills.
However, if the estate itself is named as a beneficiary of the life insurance policy, then the money from the life insurance proceeds will first and foremost go to the estate towards paying off the decedent's final bills.
On the other hand, if one or more beneficiaries (not including the estate) are named on the life insurance policy but none of the beneficiaries survives the decedent, then one of two things is likely to happen:
The life insurance proceeds will just go to the estate to pay off the decedent's final bills.
The life insurance proceeds will go to the decedent's living heirs-at-law. An heir-at-law is a close relative who would be legally entitled to inherit from the decedent if the decedent had not made a will.
Is Interest on Life Insurance Taxed?
Yes. According to the IRS, even though life insurance proceeds are not generally taxed, the interest earned on life insurance is taxable. You should report this interest as interest received.
How to Reduce These Taxes
Life Insurance
As mentioned above, a life insurance policy with named beneficiaries is a great way to distribute money among your loved ones after you are gone, without them having to worry about some tax from the state or federal government.
Give Assets Away Before Dying
If you believe that your time may be coming, even just in the next 5 to 10 years, it may be a good idea to start passing down your assets. If you pass on your assets before you pass on, then there will be nothing -- or at least -- taxable. Check out the gift tax rules in your state first, but many states will not tax gifts.
Make a Will
If you know how you want your assets to be distributed after you are deceased, then make a will. This is one of the only ways to be sure that your estate will be handled the way you want it to.
Open a Trust
If you put your assets into a trust -- such as for your children or grandchildren, then your assets can be transferred to whoever you want them to be transferred to, and you may even be able to put them in an interest-earning trust, which means even more money and help for your loved ones after you are gone.
Keep Capital Gains Tax (CGT) in Mind
If an asset (property, shared, etc.) has decreased in value since it was purchased, then it will not be liable for Capital Gains Tax. While it is not necessarily positive for something to have gone down in value, it can save some taxes for your loved ones.
Charity
While you may be more concerned with leaving money and other property to your loved ones when you are gone, it is worth considering also donating to charity. Not only does it leave a positive impact on the world after you are gone, but it also helps you and your beneficiaries. Your inheritance tax rate could decrease by 4% (from 40% to 36%) if you donate at least 10% of your total assets to charity.
Get a Tax Expert
This may be complicated to handle on your own, especially if you are dealing with the emotions of losing a loved one. If you are dealing with any of the taxes mentioned above, then speak to a tax expert. A tax expert may be able to help decrease or completely get rid of these taxes. It's their job to know all of the rules (and tricks and loopholes), so it doesn't hurt to get an expert opinion on your situation.
Spend Your Money Now!
There is no reason to only save your entire life. You can't bring your money with you after you are deceased, so spend some of it now. Enjoy the money you worked your entire life to earn. This doesn't mean leaving nothing to your loved ones, but it means enjoying some of it yourself. You deserve it. Besides, the less you have when you finally pass, the fewer proceeds there are to be taxed.
Conclusion
As you can see, "Is life insurance taxable?" is a more complicated question than it may seem at first sight. Hopefully, this breakdown helped make things a bit simpler though. Now hopefully you understand the basics of how taxes work, the difference between life insurance and an estate, the difference between an estate tax and inheritance tax, and which things are taxed.
If you are concerned about these taxes, try some of the tips above about how to reduce these taxes. While just not paying the taxes is not an option, you would be surprised at how many ways there are to either reduce or become exempt from these taxes.