When a loved one passes away and designates you as one of their beneficiaries, you’ll receive a payout from the life insurance company. However, is this death benefit considered to be an inheritance? And more importantly, will you have to pay taxes on this windfall?
This post will explore what constitutes an inheritance, where life insurance fits into the situation, and if your tax bill could be affected.
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What is Considered an Inheritance?
An inheritance is anything someone leaves behind to their loved ones after passing away. This can include a wide variety of assets, such as:
- Money (bank accounts, investments, retirement accounts, etc.)
- Real estate (their primary residence, a vacation home, rental properties, etc.)
- Other property (vehicle, jewelry, antiques, etc.)
In most cases, this property is passed down to heirs through what’s called an estate. An estate can be thought of as the collective of everything an individual owned that must now be transferred through a court process known as probate.
Is An Inheritance Taxable?
When assets are transferred, there are generally two types of taxes: estate and inheritance. The deceased’s estate pays estate taxes. However, inheritance taxes are paid by the beneficiaries.
Fortunately, there are no federal taxes due to inheritance proceeds. When it comes to the individual states, at least six states (Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania) impose inheritance taxes on their residents.
Is Life Insurance Considered to be an Inheritance?
As long as the deceased did not designate their estate as the beneficiary of the life insurance policy, it is not considered an inheritance. Therefore, heirs are not required to pay inheritance tax on this death benefit.
This is because life insurance is technically not a property that was owned by the deceased. It’s a contract between the life insurance company and the deceased’s heirs that is triggered after they pass away. In other words, the death benefit can’t be considered “their money.”
How to Avoid Inheritance Tax on Death Benefits
To ensure that the death proceeds from your life insurance contract pass on to your loved ones and don’t accidentally trigger any unnecessary inheritance taxes, you should do the following:
As we said, don’t list your estate as the beneficiary on a life insurance policy, thinking it will be distributed according to your will. Instead, list the people you want to receive these benefits directly on the contract.
Consider an ILIT (Irrevocable Life Insurance Trust)
If you have a significant amount of wealth to pass on and are looking for ways to avoid probate and lower estate taxes, then consider an ILIT. An ILIT is essentially a trust that holds a life insurance contract. The grantor can pay the life insurance policy premiums while they’re still living. Then upon death, the trust will manage the proceeds and distribute them according to the insured’s wishes.
The Bottom Line
When someone passes away and leaves you an inheritance, those assets may be subject to inheritance tax, depending on which state you live in. However, the death benefits are not considered an inheritance and, therefore, not taxable. The insured can do this by designating specific people instead of their estate as the beneficiary or by forming an ILIT.