Typically, beneficiaries don’t pay estate taxes on life insurance payouts. But like everything in life, there are exceptions to the rule. Keep reading to learn if and when you’d have to pay taxes on life insurance payouts that you inherit.
When is the Payout?
This is the most important determining factor when deciding if a beneficiary will owe taxes on life insurance proceeds. If the insured decided to wait for the payout rather than paying out upon his death, any interest that accumulates is taxable, just as any interest you earn would be taxable. You won’t pay taxes on the payout itself, but rather on the interest accrued while the money sat in an interest-bearing account.
Is the Estate the Beneficiary?
If the insured names the estate as the beneficiary rather than an actual person, it may affect your tax liability, here’s why.
Estates are taxable once they are worth a certain amount. In 2020, that amount is $11.58 million. If the insured has a large estate and the life insurance puts it over the threshold, it could incur federal taxes on the estate. Estate taxes tend to be fairly high, which can really eat away at your beneficiaries’ payout.
If you worry that your estate is nearing the maximum when you include your insurance, home, retirement accounts, and any other assets, it’s easy to reach that maximum quickly. In order to avoid it, you can transfer ownership of your life insurance. Many people transfer it to the beneficiary, but you can choose any able-bodied person.
Here’s how it works:
- You formally transfer ownership
- The new owner must make the premiums
- You can gift the new owner up to $15,000 per year to cover the premiums without taxation
- You can’t make changes to the policy
Without ownership of the life insurance policy, you don’t have to worry about it affect your estate’s value and eventual taxation.
Put the Life Insurance in a Trust
If you want to avoid the risk of taxation, put the life insurance in a trust. To do this, you must transfer ownership to the trust. The trust must meet two requirements:
- You may not be the trustee of the trust
- You may not revoke or make changes to the trust
This way when you die, the life insurance doesn’t go toward the estate, so it doesn’t count toward the estate’s value.
If you’re worried about your estate’s value or your beneficiaries paying taxes on the life insurance payout, talk with your tax advisor. See if there are ways around it so that you can structure your estate to avoid excessive taxes. If you don’t, your beneficiaries could face tax rates of up to 40%, which is something most people want to avoid. After putting all of your hard-earned money into your estate, the last thing you want to do is pay the money over to Uncle Sam – you’d rather you beneficiaries enjoyed it.