Whether you purchased a private life insurance policy from an insurance carrier or are covered by an employer-sponsored group term life plan, death benefits are generally exempt from income taxes. The Internal Revenue Service, however, can levy other taxes on your life insurance proceeds after you die. States may impose similar taxes on your life insurance proceeds as well.
Federal Estate Taxes
If your life insurance policy is part of your estate at the time of your death, the proceeds may be subject to federal estate taxes. Your estate is taxed if the total value of the property you own, including your life insurance policy, exceeds the IRS’ guidelines. As of 2012, federal estate taxes are levied against your property if the value tops $5.12 million. If you’re married, your estate’s value has to exceed $10.24 million to be taxed. The top federal estate tax as of 2012 is 35 percent.
State Estate Taxes
Depending on where you live, some states tack on their own estate taxes, which could reduce your life insurance proceeds. Generally estate tax rates are less at the state level. For example, at the time of publication, Washington state can tax your estate up to 19 percent if your property value is more than $9 million. In Illinois, the maximum estate tax rate is 16 percent.
State Inheritance Taxes
Your life insurance proceeds may be reduced by state inheritance taxes. Inheritance tax is levied against property you are passing on to other people. Tax rates vary by state and depending on who is receiving your property. For example, Kentucky levies no inheritance tax on property passed to your spouse, children or grandchildren. However, a 16 percent inheritance tax rate can be levied against property passed to nonlinear family members such as your niece, nephew and brother- or sister-in law.
Some states exempt your life insurance proceeds from inheritance taxes. Pennsylvania, for example, has a top inheritance tax rate of 15 percent, but life insurance proceeds are exempt if the beneficiary is a person and not your estate.
You may be able to avoid federal estate taxes on your property and preserve your life insurance proceeds for your loved ones. If you can transfer ownership of your life insurance policy, designate it to someone like your parent or an adult child. This may not be possible if you are covered under a group life insurance plan. The beneficiary shouldn't be your estate but someone outside of your estate such as a family member.
These changes must take place at least three years before your death or your life insurance policy will be included in your estate. If applicable, take advantage of the spousal exemption and leave your estate to your husband or wife. The increased exemption limit may be enough to keep your estate from being taxed.
- Fidelity: Estate Tax Changes for Couples
- Ryan Velo-Simpson: Washington State Estate Taxes
- Martindale: Recent Changes to the Illinois Estate Tax
- State of Kentucky: A Guide to Kentucky Inheritance and Estate Taxes
- Kevin A. Pollock BLAWG: Is There an Inheritance Tax on Life Insurance Proceeds?
- New York Life: The Tax Advantages of Cash Value Life Insurance