Taxes for Inherited Life Insurance
Who can receive it: You can leave your life insurance to anyone, although if you're naming a child or children, note that, in many states, life insurance can't be paid to minors under age 18. Talk to your estate planner about setting up a trust — or having your will create a trust when you die — to which you'd leave your life insurance proceeds. You can then name a trustee who could manage the funds until your children come of age. Life insurance beneficiaries trump your will, so keep these up to date.
Taxes involved: For most beneficiaries, the death benefit of a life insurance policy can be inherited tax-free and does not have to be reported as income. However, the heir may owe taxes on any interest earned if the benefit is held for a period of time before being distributed. And in a select few states, heirs may be subject to inheritance taxes that include the value of an inherited life insurance policy.
What to consider: If other assets will result in a hefty tax burden on your loved ones, life insurance can be a tool to help them offset the cost of their inheritance.
Taxes for Inherited Annuities
Who can receive it: You can leave an annuity to any beneficiary. As with the assets above, beneficiary designations trump your will.
Taxes involved: An heir can elect to receive an annuity as periodic or nonperiodic distributions, or as a lump-sum payout. If your heir chooses a lump sum, they'll pay taxes on anything over what you originally paid for the annuity. For periodic distributions, heirs pay taxes only on the part of the payment that stems from earnings. For nonperiodic distributions, which are amounts not received as an annuity, heirs pay taxes on everything until no distributions are left, at which points remaining payouts are tax-free.
Special caveats: If your annuity contract specifies guaranteed payments, your heir can receive tax-free payments up to the amount originally paid for the contract. Everything in addition to that is considered taxable income.
Who can receive it: You can leave your investments to anyone, and generally this is done via your will.
Taxes involved: When someone inherits a taxable investment, the cost basis of the investment becomes the value of the investment at the time of your death. If your heirs move their inherited investments into their own account and don't sell them, they may not owe any capital gains taxes. When and if they eventually sell them, they'll be subject to normal investment tax rules. (They'll owe taxes on any gains.) In some states, heirs will also owe inheritance taxes on the value of the investments.