If you have a life insurance policy, the value of the policy is paid to the beneficiary upon your death. If you don't designate a beneficiary, it is paid to your estate. If, on the other hand, you are the beneficiary of a life insurance policy, you can use those funds to pay whatever you wish, including any inheritance taxes you may owe.
Life Insurance Proceeds
If someone makes you the beneficiary of his life insurance policy, the death benefit listed in the policy will be paid to you. The estate's executor -- the person in charge of handling all the details -- will contact you to let you know when to expect the funds. Some insurance companies take longer than others to make payouts, especially if the policy is large or there is some question about whether the death was insurable. You are not responsible for paying any of the estate's debts out of your proceeds unless the will is structured that way.
Although you won't have to deal with any estate taxes -- those are paid out of funds in the estate before it is distributed to those named in the will -- you may have to pay inheritance taxes on any assets you are bequeathed, including life insurance proceeds. There is no federal inheritance tax, and each state has its own tax laws regarding these taxes. There is good news, though: States that do have the inheritance tax also stipulate exemptions based either on your relationship to the deceased or on the amount of the inheritance. Some states exempt life insurance proceeds altogether. If you inherit a sizable estate, it's always a good idea to discuss it with an experienced CPA or estate lawyer to make sure that you minimize any tax hit you may have to take.
You don't have to pay income tax on your life insurance proceeds, but if you invest them and earn income on them, you will have to pay tax on that income. Before you even get the payout, the estate will have to include the life insurance in its estate tax calculation and, if the estate has assets of more than $5.25 million, part of it will be subject to the estate tax. Those taxes must be paid before any assets can be handed out to the beneficiaries, but they will not be deducted from the life insurance proceeds.
Other Common Uses of Life Insurance
Life insurance policies can be used in many ways in estate planning. If you expect that your estate will consist of mostly real estate that you want to pass along to family members, you may be concerned that the estate might have to sell some of the properties to have enough cash to pay the estate taxes. If you take out a life insurance policy payable to the estate or a close relative, those funds can pay the estate taxes and allow the bequests to happen. You can also use life insurance to give a charity a much larger donation than you might have been able to when you were alive. As the size of your estate grows, the need for financial planning and the smart use of life insurance and other financial instruments also grows.
Angie Mohr is a syndicated finance columnist who has been writing professionally since 1987. She is the author of the bestselling "Numbers 101 for Small Business" books and "Piggy Banks to Paychecks: Helping Kids Understand the Value of a Dollar." She is a chartered accountant, certified management accountant and certified public accountant with a Bachelor of Arts in economics from Wilfrid Laurier University.