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How is Life Insurance Taxed in an Estate?

Question mark with peopleNJ.com’s recent post asks “Is inheritance tax owed on life insurance?” The article advises that it's important to understand how your assets will be taxed when you die. Here’s a review of all the rules in New Jersey. Those residents must look at three potential death taxes: the federal estate tax, the New Jersey estate tax and the New Jersey inheritance tax.

The current IRS code lets each taxpayer pass $5.49 million federally tax-free to anyone cumulatively during life or at death. There’s also the notion of portability. With portability, a surviving spouse may be able to use any unused federal estate and gift tax exemption of his or her "last deceased spouse." Therefore, with proper planning, a married couple may be able to pass at least $10.98 million federal estate and gift tax free.

The New Jersey estate tax is scheduled to be repealed next year.  However, until that time, anyone dying in 2017 can pass $2 million free of estate tax. It is important to note that the state doesn't recognize portability.

New Jersey and federal estate taxes are calculated based on the decedent's gross estate less certain deductions, like funeral and administrative expenses, debts, charitable donations and outright bequests to a surviving spouse or bequests made to the surviving spouse in the form of qualified trusts. All assets owned or controlled by the decedent are typically going to be included in the gross estate. This will include any life insurance owned or controlled by the decedent and paid to either a third-party beneficiary or the estate.

However, the state’s inheritance tax is assessed differently—it’s levied against certain bequests and transfers within three years of death, based on the relationship between the deceased and the beneficiary, and the value and nature of the asset transferred. There’s no inheritance tax imposed, if the beneficiary is a spouse, domestic partner, civil union partner, grandparent, parent, descendant or stepchild of the decedent (called “Class A beneficiaries) or a charity. The value and nature of the bequests are irrelevant, if the beneficiary is in one of these categories. These relationships are exempt from inheritance tax. If the beneficiary is not in one of these categories, then the relationship to the beneficiary and the value and/or nature of the bequest must be examined.

Some assets are also exempt from the New Jersey inheritance tax, such as life insurance. But it must be paid to a named beneficiary or a trust for the benefit of that beneficiary. Life insurance owned by a decedent isn’t exempt from the inheritance tax, if it’s paid to the estate.

Reference: NJ.com (March 28, 2017) “Is inheritance tax owed on life insurance?”

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