Life Insurance vs. Inheritance: Key Tax Differences
Whether you have a young family that would need financial support if you were to pass away, or you want to make sure your spouse has plenty to live off of throughout retirement, life insurance plans are an effective way to keep that money in the family rather than going to the IRS.
Here are some key facts you need to know about how life insurance stacks up against a typical inheritance.
Do you pay inheritance tax on life insurance?
A death benefit is the cash a beneficiary receives from an insurance company as payout for an individual’s life insurance policy. This can end up being a lot of money; Ethos, for instance, offers policies for as much as $2 million. Consequently, it’s natural to wonder if a life insurance benefit is taxable.
In most cases, no: beneficiaries do not pay taxes on a life insurance payout. A death benefit doesn’t count as income, nor is life insurance considered part of an estate (which comes with its own set of taxes). That makes life insurance an effective tool in estate planning.
You can certainly calculate coverage to get a policy that covers lost income, outstanding debt, and final expenses. But you can also get a life insurance policy simply as a way to leave behind an inheritance that isn’t diminished by taxes.
How inheritance tax works
Both the federal government and some states charge a tax on a certain amount of assets after a person passes away. However, the federal tax doesn’t apply to amounts under the limit.
In 2021, the threshold was $11.7 million for individuals and $23.4 million for married couples. That means any inheritance under that amount is not taxed at all. In 2022, the threshold jumped to $12.06 million for individuals and $24.12 million for married couples. If you do receive an inheritance over the limit, then the tax rates range from 18% to 40%.
In the U.S., the average inheritance is $46,200. Most people don’t need to worry about inheritance taxes at all – at least for now. The $11.7 million cap is a temporary extension and is set to expire on December 31, 2025. Unless a new tax law is passed to extend the higher limit, the inheritance will go back to applying to any amount over $5 million (although this will likely be closer to $6 million when adjusting for inflation). When thinking about estate planning and taxes, it’s smart to pay attention to changes in the legislative landscape and look ahead.
Can life insurance cover inheritance tax?
Life insurance can be part of your inheritance tax planning. If you’re anticipating leaving a large estate to your heirs, a life insurance policy can be a tax-free way to limit the loss of wealth because of inheritance taxes.
It’s also important to check your state laws on inheritance taxes. Your state could have a lower limit on the size of the estate that’s taxable. Even if your estate wouldn’t be subject to federal taxation, your heirs may have to pay state taxes. Life insurance can help cover those costs.
Exceptions to life insurance tax rules
There is an exception to life insurance benefits being free from taxes after your death. In some cases, a policy benefit may earn installment interest.
Say the policy holder designates the funds to be distributed to the beneficiary over a period of time (this is more common if the beneficiary is a minor). If the funds earn any interest while being held by the insurance company, the interest earned will be taxable when distributions are made. In other words, the death benefit itself isn’t taxed, but the interest is taxed as ordinary income.
Likewise, there may be tax implications if the insured person is subject to estate taxes. Finally, gift taxes may apply in situations where three different parties fill the roles of policyholder, insured individual, and beneficiary.
Having an online life insurance policy is a great way to leave behind a tax-free inheritance. When planning your estate, be sure to consult a tax professional regarding your personal situation.
No matter what amount you expect to leave behind for your family, you can’t predict how future tax laws will treat inheritance limits. But you can count on life insurance falling into a separate category that isn’t taxed in most situations.
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