People buy life insurance to provide financial security to their loved ones. Life insurance benefits are paid free of income taxes. However, depending on where you pass away and the value of your estate, you or the policy’s beneficiary might have to pay other taxes on the proceeds.
State Inheritance Tax
As a life insurance beneficiary, you generally are responsible for paying inheritance taxes. States levy inheritance taxes and set their own tax rates and exemption amounts. You might be exempt from paying inheritance taxes based on your relationship to the policyowner. Many states exempt proceeds if the beneficiary is a linear family member of the policyowner such as a spouse, parent, grandparent, brother, sister, child or grandchild. Some states, such as Pennsylvania, exempt life insurance proceeds from inheritance taxes whether or not a beneficiary is named.
State Estate Tax
Another state tax that may decrease your benefits is estate tax. Unlike inheritance tax, estate tax is levied against a deceased person’s property before it is passed to anyone else, if the value exceeds the state’s exemption limit. A life insurance policy is part of an estate if that policy is owned by the deceased person at the time of death. States with both inheritance and estate taxes, such as New Jersey and Maryland, have separate exemption limits and tax rates.
Federal Estate Tax
The Internal Revenue Service also has an estate tax policy. The same rules apply, as life insurance is considered part of an estate if the person owns the policy when he dies. Unlike states' varying estate tax policies, the federal estate tax rate and exemption amount is uniform across the country. As of 2012, your estate is taxed if your property value tops $5.12 million, or $10.24 million if you’re married. The IRS can levy a top tax rate of 35 percent on your estate, depending on its value.
Policyowners can take steps to ensure that proceeds are free from taxation. To prevent policies from being included in estates, they can transfer ownership to someone such as their adult children. Also, naming a beneficiary to someone outside of the estate, such as a parent, will protect the policy from estate taxes. Another option is to set up life insurance trusts that will own and be the beneficiaries of the policies. Trusts can be expensive, and policyowners can't change them after they're set up. Policyownership/beneficiary changes and trusts must be done at least three years before the policyowner's death, or the policy will be included in the estate.