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Monday, March 5, 2012

Is there an Inheritance Tax on Life Insurance Proceeds?

One of the biggest misconceptions people have about life insurance is how it should be taxed. Most people think that they can receive the proceeds completely tax free. Upon the death of the insured, the beneficiary of a policy can almost always receive the proceeds without paying an income tax. However, estate taxes and inheritance taxes are a different matter.

If the insured owns a life insurance policy on his or her own name, it is subject to the federal estate tax. It is also subject to the state estate taxes of many states, including the
New Jersey Estate Tax and the New York Estate Tax. This is one of the reasons many people have a life insurance trust own the life insurance on their lives. It is also one of the reasons that many people name their children as the owners of their life insurance policies.

The inheritance tax has its own set of rules for how a life insurance policy should be taxed. In Pennsylvania, the death benefit from a life insurance policy is always free of inheritance tax.  


However, in New Jersey, it depends upon whether the policy is payable to an individual beneficiary or the estate of the insured.  If the policy is payable to an individual in New Jersey, then there is no inheritance tax.  If the policy is payable to the estate of the insured, then there may be an inheritance tax depending upon who the beneficiary of the estate is.

Under the New Jersey Inheritance Tax scheme, if the proceeds pass to a spouse, civil union partner, child, grandchild, parent, grandparent or a charity, then there is no inheritance tax. However, if the money passes to a sibling, then there could be anywhere from an 11-15% inheritance tax. Generally, if the money passes to anyone else, then there is a 15-16% tax depending upon how much is transferred.

As a result of these rules, it is usually best to consider who will be a beneficiary of your estate before deciding which assets you wish to go to whom. For example, if you know you want to benefit a niece or a nephew, using life insurance is one of the most tax efficient ways to do it.

Please
contact us if you wish to discuss planning with life insurance in more depth.

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Updated on 12/31/12. 

3 comments:

Benzgirl33 said...

I'm trying to find out if my dad is responsible to pay state or federal taxes in PA on a life insurance policy that was owned by his wife. His wife recently passed and the payout was to him as a surviving spouse. Each article becomes more confusing to me in order to give him the appropriate answer. His wife was the owner of the policy and it was not substantial, $100,000. Can someone explain whether or not this payout is taxable? From what I gather it is not but I want to be certain. Thank you!!

Kevin A. Pollock, J.D., LL.M. said...

Dear Benzgirl33,

The technical answer to your question is that:
1) Pennsylvania does not have an inheritance tax on life insurance; and
2) The federal government does include life insurance in the taxable estate of your father's wife. However, if your step-mother's estate is under $5,430,000, then no tax is due. Also, if your step-mother's estate claims the marital deduction for assets passing to your father, then no tax is due either.

So, if your step-mother had significant wealth, I strongly recommend that the executor speak with a tax attorney to discuss options.

Ritika Shah said...
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