Do you have to pay taxes on money received as a beneficiary? The general answer to my blog title is no; not usually. Most times beneficiaries do not have to pay income or death taxes on the proceeds from life insurance policies. Let’s talk about these situations.
There are some situations where beneficiaries have to pay taxes on a life insurance payout:
- The insurer issues the death benefit in installments: With some policies, instead of a lump sum payout, a life insurance beneficiary receives the death benefit in installments. When this happens, the insurer typically holds the policy in an interest-bearing account and issues a percentage of the death benefit over a set number of years. Although the original death benefit is tax-free, the interest that accumulates is subject to income tax.
- The death benefit becomes part of your estate: The federal estate tax exemption limit in 2023 is over 12 million dollars, to be indexed further up in 2024 and 2025. This means if an estate’s total taxable value is greater than this amount, the IRS levies an estate tax. If you know your estate won’t exceed 12-13 million dollars, you don’t need to worry about this tax. Plus, proceeds left to beneficiaries in an irrevocable life insurance trust are exempt from estate tax, even if their value exceeds the federal limit. But if you personally own your life insurance policy when you die (meaning ownership is in your name personally and not in an irrevocable life insurance trust), then the value of the policy payout is included in your estate, regardless of whether you name a beneficiary. This could push your estate’s total taxable value over the federal exemption limit if you already have a sizable estate. In addition to the federal estate tax, some states (not New Jersey), levy estate and death tax. Exemption limits vary among states.
What should you do?
Creating an irrevocable life insurance trust is the best way you can exclude the value of a life insurance policy from being included in your estate. Relatively inexpensive, especially considering the potential death taxes that may be incurred if your estate grows in value or if the Biden administration seeks to punish financially successful people by dramatically reducing the death tax exemption threshold set to expire in 2026. But if your estate is less than 2.5 million dollars, you likely do not have to invest in having an irrevocable trust prepared.
I am always happy to answer any questions about life insurance and estate planning.
To discuss your NJ estate planning matter, please contact Fredrick P. Niemann, Esq. toll-free at (855) 376-5291 or email him at fniemann@hnlawfirm.com. Please ask us about our video conferencing or telephone consultations if you are unable to come to our office.
By Fredrick P. Niemann, Esq. of Hanlon Niemann & Wright, a Freehold Township, Monmouth County, NJ Estate Planning Attorney