Do You Pay Inheritance Tax on Life Insurance?

In most cases, life insurance proceeds become part of your estate and are potentially subject to the inheritance tax. The good news is that most people won’t have to pay estate taxes.

This post is provided for general information only. Please confirm the details and circumstances of your unique situation with your tax accountant or other appropriate advisor before taking action.

When do life insurance proceeds become part of your estate?

There are two primary ways your life insurance payout can become part of your estate. If you want to read the technical details, start with Internal Revenue Code 20.2042-1.

Your estate is your life insurance policy beneficiary.

The first way is simple. If you designate your life insurance proceeds to be paid to your estate, they’ll become part of your estate.

Many people choose this option so they can cover potential debts and divide any remaining proceeds according to the will. This can avoid having to add or remove beneficiaries during your life.

Naming your estate as the beneficiary of your life insurance policy does not guarantee that your life insurance payout will be subject to estate taxes. See more below.

You have a designated beneficiary but keep incidents of ownership.

Another way that your life insurance policy can become part of your estate is if you keep incidents of ownership. Incidents of ownership mean that you can receive some sort of financial benefit from holding the life insurance policy.

Incidents of ownership can include:

  • Being able to change the beneficiary

  • Being able to take out a cash value from the life insurance policy

  • Being able to borrow against the cash value

  • Being able to cancel or surrender the policy

  • Being able to assign the policy to someone else or revoke an assignment

  • Being able to use the policy as collateral for a loan

The key here is that you have a right to do something with your life insurance policy whether or not you exercised the right. For example, if you never changed the beneficiary but had a right to do so, the policy would generally count as part of your estate.

Again, being part of your estate does not necessarily equal paying estate tax.

When is a life insurance payout subject to federal estate tax?

Once life insurance payouts become part of your estate, the usual rules for federal estate taxes kick in. Generally, your estate will have to pay estate taxes if the total of your life insurance death benefits, other assets in your estate, and lifetime gifts is more than the estate tax exemption.

In 2022, the estate tax exemption is $12.06 million. So unless you have more than $12.06 million in potential life insurance payouts or other assets, you generally don’t need to worry about an inheritance tax on life insurance.

In 2023, 2024, and 2025, the estate tax exemption will likely slightly increase due to annual inflation adjustments. However, in 2026, the exemption will drop to about $6.2 million due to the expiration of provisions in the 2018 Tax Cuts and Jobs Act that increased the estate tax exemption.

Exception for Spouses

If all or part of your life insurance death benefit goes to your spouse, additional rules come into play.

Transfers to your spouse are generally exempt from estate tax with no limit. So even though a life insurance policy with your spouse as a beneficiary will usually be part of your estate, you generally won’t need to worry about estate taxes.

If your spouse doesn’t spend all of the money, it would later become part of his or her estate just like any other cash assets.

Do beneficiaries of life insurance policies pay income tax?

As a general rule, beneficiaries of life insurance policies don’t pay income taxes on the death benefit.

Beneficiaries pay taxes on interest income when they choose to receive installment payments or otherwise delay payment of their life insurance benefits.

Is being a beneficiary of life insurance considered an inheritance?

Whether a life insurance policy is an inheritance depends on what you mean by inheritance.

If you’re asking as a family matter whether life insurance is an inheritance, the beneficiary generally benefits just as much from receiving $1 million in life insurance proceeds as they do from receiving $1 million from a savings account.

For taxes, there generally isn’t a tax for inheriting money. The inheritance tax is actually the estate tax that’s paid by the estate if the estate is big enough.

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