Is Life Insurance Considered Inheritance?

Life insurance serves as a contract where an insurer provides a sum of money, known as a death benefit, to a designated beneficiary upon the insured individual’s death. The question of whether these proceeds are considered “inheritance” is a common inquiry, and the answer is not always straightforward, depending on the legal, tax, and probate contexts involved. Understanding the mechanisms of life insurance payouts and their specific treatment is important for both policyholders and beneficiaries.

How Life Insurance Proceeds Are Paid

Life insurance benefits are paid directly to the named beneficiary or beneficiaries upon the insured’s death. This direct payment mechanism allows the proceeds to bypass the lengthy probate process. Beneficiaries can be individuals, multiple people, trusts, or even entities like charities.

The process of claiming life insurance proceeds involves the beneficiary submitting a death certificate and policy information to the insurance company. Most states have regulations allowing insurers a period to review the claim before payment. The policyholder’s designation of beneficiaries is an important element, as it dictates who receives the funds, overriding instructions in a will.

Payouts are commonly received as a lump sum, providing immediate access to the full amount. Beneficiaries may also have options for installment payments or annuities, where the proceeds are paid out over time with accrued interest.

Tax Treatment of Life Insurance Proceeds

Life insurance proceeds paid to a beneficiary are not subject to federal income tax. However, if the proceeds are held by the insurer and accrue interest before being paid out, that interest component is subject to income tax for the beneficiary.

Life insurance proceeds can be included in the deceased’s taxable estate for federal estate tax purposes. If the deceased owned the policy at the time of death, its value is included in their gross estate. For 2025, the federal estate tax exclusion amount is $13.99 million per individual, meaning estates valued below this threshold do not incur federal estate tax.

Some states impose their own estate taxes or inheritance taxes. An inheritance tax is levied on the recipient of inherited assets, but life insurance proceeds paid directly to a beneficiary are exempt from these state-level inheritance taxes. However, if the life insurance proceeds are paid to the deceased’s estate, they may become subject to state estate or inheritance taxes if the estate exceeds the state’s exemption thresholds.

Life Insurance Versus Other Inherited Assets

A primary distinction of life insurance proceeds is their bypass of the probate process. Unlike assets like real estate, bank accounts, or investments that are distributed through a will, life insurance paid to a named beneficiary goes directly from the insurer to that individual. Probate is the legal process of validating a will and overseeing the distribution of an estate’s assets, which can be time-consuming and involve court fees.

Life insurance proceeds, when paid directly to a beneficiary, are protected from the deceased’s creditors. Assets that pass through probate, conversely, are subject to creditor claims and outstanding debts before being distributed to heirs. This protection provides beneficiaries with more immediate and secure access to funds.

The policyholder maintains control over who receives the life insurance benefit by designating beneficiaries, a decision that stands separate from a will. This direct designation allows for quicker distribution of funds compared to the lengthier process of settling an estate through probate, which can take months or even years.

When Life Insurance May Be Part of an Estate

Life insurance proceeds can become part of an estate, and thus subject to probate and potential estate taxes. If the deceased’s estate is designated as the beneficiary of the life insurance policy, the proceeds will be paid to the estate. In this situation, the funds become part of the probate process, making them accessible to creditors and distributed according to the deceased’s will or state intestacy laws if no will exists.

Another instance occurs if all named primary and contingent beneficiaries predecease the insured, and no other beneficiary is designated. In such cases, the life insurance company may default to paying the proceeds to the insured’s estate, leading to probate. Regularly reviewing and updating beneficiary designations, especially after significant life events, can prevent this outcome.

If the deceased possessed “incidents of ownership” over the policy at the time of death, the policy’s value is included in their taxable estate for federal estate tax purposes. Incidents of ownership refer to economic control over the policy, such as the right to change beneficiaries, surrender or cancel the policy, borrow against its cash value, or assign it. To avoid inclusion in the taxable estate, policy ownership can be transferred to another individual or entity, although a three-year look-back rule applies to such transfers.

Irrevocable Life Insurance Trusts (ILITs) are a planning tool used to hold life insurance policies. By having an ILIT own the policy, the insured avoids retaining incidents of ownership, thereby keeping the death benefit out of their taxable estate and bypassing probate. This strategy can provide estate tax reduction and ensure liquidity for heirs outside of the estate.