Q. Is money received through a life insurance policy taxable In New Jersey? Say you have an estate worth $980,000 and life insurance of $100,000. Which amount is the estate taxed for? I’ve also read that children of the deceased are exempt of tax as Class A beneficiaries. Is that correct?
— Planning ahead

A. Estate taxes can be complex, so here goes.

Life insurance proceeds are income tax free to your beneficiaries.

However, if the policy is individually owned by the insured, the death benefit is included in your taxable estate and is subject to both federal and New Jersey state estate taxes, but only when your estate is worth more than the current exemption limits, said Matthew DeFelice, certified financial planner with U.S. Financial Services in Fairfield.

For 2016, the federal estate and gift tax exemption is $5.45 million. This means that an individual can leave $5.45 million to heirs and pay no federal estate or gift tax, DeFelice said.

“A married couple will be able to shield $10.9 million from federal estate and gift taxes, assuming they haven’t made any prior lifetime gifts,” he said. “The unlimited marital deduction allows you to leave all or part of your assets to your surviving spouse free of federal estate tax.”

But in order to use your late spouse’s unused $5.45 million exemption, you have to elect it on the estate tax return of the first spouse to die, even when no tax is due.

So in your question, an estate worth $980,000 plus a life insurance death benefit of $100,000 would not have to pay any federal estate taxes, DeFelice said.

But then there’s New Jersey.

New Jersey is one of only two states that charges both an estate tax and an inheritance tax, DeFelice said.

Under current law, estates with a total value of more than $675,000 are subject to the New Jersey estate tax when inherited by anyone other than the deceased person’s spouse, he said.

“Any property you leave to your spouse is exempt from state estate tax, no matter what the amount,” he said. “So with the $1,080,000 estate in question — including life insurance proceeds — $405,000 would be subject to New Jersey state estate taxes when passed to your children.”

DeFelice said New Jersey charges an inheritance tax on estates worth more than $25,000, but only to certain heirs, not all. Beneficiaries who are the surviving spouse, children, grandchildren, and parents of the deceased are entirely exempt and will not pay any state inheritance tax, regardless of the size of the estate. Other relatives, such as siblings and the spouses or partners of deceased children, are taxed on estates over $25,000.

The rate starts at 11 percent and rises to 16 percent, depending upon the amount inherited.

DeFelice said many folks are confused because they either get misinformation from life insurance agents or what they read online, and they’re not aware of the tax consequences of having a life insurance policy included in your estate.

“One way to avoid this is to create an irrevocable trust that owns the life insurance policy, thereby removing it from your taxable estate – commonly called an ILIT, or Irrevocable Life Insurance Trust,” DeFelice said.

You’ll need to have an estate planning attorney draft the trust and name whatever beneficiaries you want (typically your spouse and/or children) along with the supporting documents that need to be filed each year.

Then when you apply for a life insurance policy, the trust is listed as the owner and beneficiary of the policy. You make an irrevocable gift to the trust each year in the amount of the policy premiums, and then the trust pays for the policy with the funds gifted.

“When you pass away, the trust inherits the proceeds from the life insurance, and distributes the money to the named trust beneficiaries – income, federal, and state estate tax free,” DeFelice said. “By not owning the life insurance policy personally, it is an asset not included in your taxable estate and therefore not subject to federal or state estate taxes.”

As with any estate planning, you should consult with your financial planner and an estate attorney to make sure this is a solution that makes sense for you because there will be a cost involved to draft the trust documents, DeFelice said.

“But for most folks investing a modest amount up front will wind up saving a much bigger chunk down the road for their beneficiaries,” he said.

Karin Price Mueller writes the Bamboozled column for The Star-Ledger and she’s the founder of NJMoneyHelp.com. Click here to sign up for the NJMoneyHelp.com weekly e-newsletter. Like NJMoneyHelp.com on Facebook and follow it on Twitter.

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