Are You Taxed on Inherited Life Insurance Money?

If you're named as the beneficiary of a life insurance policy, you may expect a substantial windfall upon the death of the policyholder. Depending upon the size and structure of the payout, this may feel like a sizable inheritance. After all, you'll summarily be awarded a six-figure sum of money simply for enjoying a relationship with the policyholder. Once you've come to grips with the fact that this life insurance payout will provide you with a substantial income boost, you might wonder about the tax implications of your benefits. Under normal circumstances, such a windfall would surely increase your tax liability.

However, the country's tax code doesn't treat life insurance payouts as regular income. In fact, life insurance benefits and certain other types of insurance payments are assigned to a separate, special income class. If you're in line to receive life insurance benefits, there are a few things that you should keep in mind.

First, your life insurance benefits may not be subject to taxation. Although it might not make immediate sense, taxes have already been paid on the money that you stand to receive after your policyholder's death. Since the policyholder used his or her regular, taxable income to pay the premiums on his or her policy, the "face value" that the policy has accrued has already been subject to taxation at regular marginal rates. Any tax scheme that applied additional income taxes to the policy's eventual payout would technically amount to "double taxation." Since the IRS tries to avoid "double-taxing" its taxpayers in most situations, it makes sense that most life insurance benefits should be tax-free.

In this sense, life insurance benefits aren't considered to be part of the beneficiary's "inheritance." If you receive additional inheritance income from the policyholder, it will be subject to taxation at the applicable rates. If your benefactor was particularly wealthy, your inheritance might be subject to a tax rate of 55 percent. This rate applies to estates that are worth several million dollars or more. If your benefactor was not particularly wealthy, you'll simply need to pay regular income taxes on your inheritance.

There are certain circumstances in which life insurance benefits can be taxed. If the benefits transferred to an estate or trust immediately after the policyholder's death, they will be taxed at the appropriate estate-tax rates after being disbursed to the estate's beneficiary. For this reason, it makes little sense to use an estate as an intermediary for the transfer of life insurance benefits.

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