28 Mar Is inheritance tax owed on life insurance?

Q. I just redid my will and updated beneficiaries for $500,000 in life insurance policies. Half of each policy goes to my estate and half goes to named individuals. Will there be state or federal estate or inheritance taxes? I’m not sure after reading your recent story.
— Confused

A. It’s important to understand how your assets will be taxed when you die, so let’s review all the rules before we get to your specific question.

Residents of New Jersey have to consider three potential death taxes: the federal estate tax, the New Jersey estate tax and the New Jersey inheritance tax.

And if you own real property in other jurisdictions, there may be other state taxes to consider.

To your question, current IRS code currently allows each taxpayer to pass $5.49 million federally tax-free to anyone cumulatively during life or at death, said Catherine Romania, an estate planning attorney with Witman Stadtmauer in Florham Park. She notes this amount is scheduled to increase each year for inflation.

Also note the IRS recognizes a concept known as “portability.” This means a surviving spouse may be able to use any unused federal estate and gift tax exemption of his or her “last deceased spouse,” Romania said. This means a married couple, with proper planning, may be able to pass at least $10.98 million free of federal estate and gift tax.

Then in New Jersey, the estate tax is scheduled to be repealed as of Jan. 1, 2018. Until then, for anyone dying in 2017, each taxpayer can pass $2 million free of estate tax, and the state doesn’t recognize portability.

Romania said both the New Jersey and federal estate taxes are calculated based on the decedent’s gross estate less certain deductions, such as funeral and administrative expenses, debts, charitable donations and “outright bequests to surviving spouses or bequests made to the surviving spouses in the form of qualified trusts.”

Generally, Romania said, all assets owned or controlled by the decedent are included in the gross estate, including life insurance owned or controlled by the decedent and paid to either a third party beneficiary or your estate.

The New Jersey inheritance tax is assessed differently.

“It is 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,” Romania said.

There is no inheritance tax imposed if the beneficiary is a spouse, domestic partner, civil union partner, grandparent, parent, descendant or stepchild of the decedent, also referred to as Class A beneficiaries, or a charity, Romania said.

“The value and nature of the bequest are irrelevant, provided the beneficiary falls within one of these categories, since these relationships are exempt from inheritance tax,” Romania said. “If the beneficiary does not fall within one of these categories, then the relationship to the beneficiary and the value and/or nature of the bequest must be considered.”

This is why who you name to receive assets matters.

Transfers to a sibling or son-in-law or daughter-in-law, referred to as Class C beneficiaries, are not taxable up to the first $25,000. Transfers in excess of $25,000 up to $1.1 million are taxable at the rate of 11 percent. The rate then increases to 13 percent up to $1.4 million, 14 percent up to $1.7 million and 16 percent thereafter, Romania said.

Class D beneficiaries are all other transferees and are taxed at the rate of 15 percent on transfers up to $700,000 and at 16 percent on transfers in excess, Romania said.

What’s more, certain assets are exempt from the New Jersey inheritance tax. These include life insurance, but only when it’s paid to a named beneficiary or a trust for the benefit of such beneficiary, Romania said. Life insurance owned by a decedent is not exempt from the imposition of inheritance tax if paid to the estate.

Now to your specific question: What if you own a $500,000 life insurance policy, and half is payable directly to named beneficiaries, including Class C and D beneficiaries, and half goes to your estate?

The portion payable directly to the named Class C and Class D beneficiaries would incur no inheritance tax because it’s paid directly to your beneficiaries, Romania said.

The portion payable to your estate would also incur no inheritance tax but only if your entire estate was payable under your will to Class A beneficiaries — for example your spouse and/or children — or charities because these beneficiaries are exempt from inheritance tax, Romania said.

But if one or more of the beneficiaries in your will were a sibling or son-in-law or daughter-in-law, it’s possible you would have an inheritance tax because the life insurance is passing to these Class C beneficiaries through your estate instead of directly to the named beneficiaries from the life insurance company, Romania said.

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This post was first published in March 2017.