Tax Consequences of a Life Insurance Inheritance

What Happens to a Policy When the Insured Dies?

Life Insurance

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Life insurance inheritances go directly to the beneficiaries named on the policies. They typically don't become part of the decedent's probate estate, so you should be spared the headache of probate. However, inheriting life insurance can bring tax and other consequences.

How to Collect a Life Insurance Inheritance 

If your loved one has died and you're named as the beneficiary on their life insurance policy, you can collect the insurance proceeds by sending the original death certificate and the original life insurance policy to the insurance company. The company will transmit the money directly to you. It does not become part of your loved one's probate estate, although it may contribute to his gross estate for estate tax purposes. 

Income Tax Consequences of a Life Insurance Inheritance

You do not have to pay income tax on the initial insurance proceeds when you're the beneficiary of the life insurance policy. The Internal Revenue Service does not consider death benefits to be income. But if the policy earns income after the date of death, such as because you don't take the benefits in one lump sum but rather stretch out installments over a period of years and the balance earns interest, this would be taxable. You must include it on your tax return just as you would report any other interest you earned during the tax year.

Estate and Inheritance Tax Consequences

There is no inheritance tax at the federal level, but six states do impose this tax as of 2017: Nebraska, Iowa, Kentucky, Pennsylvania, New Jersey and Maryland. This is not an income tax, but rather a percentage of the value of assets you inherit. Some states that do have inheritance taxes, such as New Jersey, specifically exempt life insurance proceeds from taxation. 

A decedent's estate is liable for federal estate taxes if it is valued at more than $5.45 million as of 2017. Any balance of value over this threshold is taxable. Fifteen states and the District of Columbia also impose estate taxes, typically with much lower exemptions. Life insurance proceeds contribute to the value of a decedent's taxable estate if the decedent was the owner of the policy or if they transferred ownership, such as into an irrevocable living trust, within three years of their death.

Beneficiaries of life insurance proceeds are not usually responsible for paying the estate tax unless the decedent's last will and testament contain specific provisions asking them to contribute some of the proceeds to satisfy the tax burden. This is rare. 

The Insured's Final Bills

A common question that comes up whether the named beneficiary on a life insurance policy is required to use any of the insurance proceeds to pay off the decedent's debts. In general, the answer is no.

The probate process involves paying off the deceased's creditors from estate funds and, if necessary, liquidation of estate assets. Life insurance proceeds that go directly to a named beneficiary never become part of the decedent's probate estate, so the money is not available to creditors and the beneficiary has no legal obligation to use the money to satisfy the decedent's debts.