Income Taxes
Life insurance proceeds are not subject to income tax. However, a beneficiary is taxed on the proceeds of any life insurance policy that he or she purchased. The amount taxed would be the life insurance proceeds received minus the consideration paid for the policy and any premiums paid by the beneficiary.

For example, if Sally gives Uncle Bob $10,000 cash in exchange for being his named beneficiary on his $100,000 life insurance policy, Sally must include $90,000 as income upon receipt of the life insurance proceeds ($100,000 policy proceeds received minus $10,000 consideration paid).

Basis Issues Related to Gifts and Inherited Assets
Generally, a beneficiary does not pay income tax on the receipt of a gift or inherited property. However, a beneficiary may incur income tax liability in the form of capital gain or capital loss when the gift or inherited property is later sold by the beneficiary. A beneficiary will owe capital gains taxes on any profits he or she receives-the difference between the basis of the property and the selling price of the property.

To determine the amount of tax liability the beneficiary must know the gift or inherited property basis—the purchase price of the property with various adjustments. Taxes on inherited or gift property, has a different tax structure, based on whether the property was received as a gift during life or inherited.

Calculating Basis for Gifts
When property is received as a lifetime gift, the recipient of the gift (donee) takes the giver's (donor's) basis. When the donee later sells the property, he or she will have to pay capital gains taxes on any increase in value realized during both the time the donor owned the asset, and any appreciation realized since the donee received the gift.

For example, Aunt June bought a stock in 1970 for $10,000 and then in 1990 she gave the stock to Nephew Karl when it was worth $40,000. In 2003, Karl sells the stock for $75,000. Karl will have to pay capital gains tax on the profits received when he sold the stock. Nephew Karl acquired Aunt June's basis (purchase price) of $10,000 and he realized a profit of $65,000 (when he sold the stock for $75,000). Therefore, Nephew Karl will owe capital gains taxes on the $65,000 profit.

Determining the basis of gifted property that is sold at a loss is a little different from the calculation above. If the donee sells the gifted property at a loss, the donee's basis is the lower of the donor's basis or the fair market value (FMV) of the property at the date of the gift. For example, Aunt Kay bought stock in 1970 for $30,000 and in 1990 she gave the stock to Nephew John when it was worth $40,000. In 2003, John sells the stock for $15,000. Because the basis on a loss is the lower of the donor's basis or the FMV at the date of the gift, Nephew John's basis is $30,000—Aunt Kay's basis. Therefore, John will have a capital loss of $15,000 (price sold $15,000 minus basis $30,000)

Another example: Aunt Liz bought stock in 1970 for $30,000 and in 1990 Aunt Liz gave the stock to Nephew Tim when it was worth $10,000. In 2003, Nephew Tim sells the stock for $2,000. Because basis on a loss is the lower of the donor's basis or the FMV at the date of the gift, Nephew Tim's basis is $10,000—the FMV at the time the gift was made to Tim. Therefore, Tim will have a capital loss of $8,000 (price sold $2,000 minus basis $10,000).

Calculating Basis for Inherited Property
When property is received as an inheritance, the beneficiary's (donee's) basis is "stepped-up" or "stepped-down," meaning the beneficiary's basis of the inherited property is the value on the date of the donor's death—instead of the donor's basis in the property. Therefore, a beneficiary will pay capital gains taxes only on any gains or losses realized on the asset after the decedent's death.

Example 1: Aunt Lisa bought stock in 1970 for $10,000 and in 1990 Aunt Lisa dies and leaves the stock, worth $40,000, to Nephew Sam. In 2003, Nephew Sam sells the stock for $75,000. Nephew Sam's basis in the stock is $40,000 (the value of stock on the date of Aunt Lisa's death). Therefore, Nephew Sam will owe capital gains taxes on the $35,000 profit—the capital gains realized from the time of receipt of the inherited property to the time of the sale of the inherited property.

Example 2: Aunt Kathleen bought stock in 1970 for $50,000 and in 1990 Aunt Kathleen dies and leaves the stock, worth $20,000, to Nephew Logan. In 2003, Nephew Logan sells the stock for $15,000. Nephew Logan's basis in the stock is $20,000 (the value of stock on the date of Aunt Kathleen's death). Therefore, Nephew Logan will have a capital loss of $5,000 (price sold $15,000 minus basis $20,000).

Tax Planning—Gift Versus Inheritance
Deciding whether to give property during life or wait to give the property at death affects the taxes paid when the person receiving the property ultimately sells the property. If an asset has appreciated, there may be significantly less taxes owed by the beneficiary if that person receives the property through inheritance.

However, there are many other tax considerations you may take advantage of, such as annual gift-tax exclusions, direct payment to an educational institution or medical provider for the benefit of the beneficiary, and changing tax laws. Consult a qualified estate planning professional to answer specific questions.

Estate Taxes
Although life insurance death benefits are generally not subject to income tax, they are subject to estate tax. If you own a life insurance policy that insures your life, generally the proceeds will be included as a part of your taxable estate if any the following conditions are met:

• the proceeds are paid to your estate
• the designated beneficiary of your life insurance proceeds is legally obligated to use the proceeds to pay the estate's obligations
• you had any "incidents of ownership" of the policy within three years of your death

Incidents of ownership means any control of terms of the policy, including the right to modify beneficiary designation, your right to borrow against the policy, and your right to assign, modify, or revoke the assignment of the policy to another party. There are legal techniques to remove the death benefits of life insurance from your taxable estate. You should consult a competent estate planning attorney if the death benefits of your life insurance would cause your estate to be greater than $1 million.

Tax Effects of Inheriting a Traditional IRA
Traditional IRAs (not Roth IRAs) are generally funded with pre-tax funds. This means that the funds in the IRA grow tax-deferred until withdrawn. When the owner of an IRA withdraws the funds, those withdrawals are taxable income. IRA owners must begin to take minimum distributions from the IRA plan no later than the April 1st following the year in which the owner turns age 70 1/2.

Roth IRAs are not subject to the minimum distribution rules during the owner's lifetime, but beneficiaries are subject to rules after the owner's death. If the owner of a traditional IRA dies before having withdrawn all of the funds, the recipients of the traditional IRA will pay income tax as they receive the funds.

There are several complex options that may be available to the recipients in determining when and how the funds are received and taxed. The available options depend on the rules of the IRA plan, how the recipient was named in the beneficiary designation, the age of the deceased owner, and the relationship of the recipient to the deceased owner.

IRA Plan Rules
The rules discussed below are the maximum options permissible under the Internal Revenue Code. The cardinal rule is that the rules of the plan document always takes precedence.

How the Beneficiary Was Named
The Internal Revenue Code has very strict rules to determine whether a person is named as a beneficiary of an IRA or other retirement plan. Generally, for there to be a "designated beneficiary" of an IRA or retirement plan, that person must be named on the beneficiary designation form in one of three ways:

1. by specific name, such as "Jane Doe"
2. by category, such as "my children"
3. under the terms of the IRA contract, such as "if the owner is married and has not named someone else, this plan will treat the owner's spouse as the designated beneficiary"

If the beneficiary is not named in one of these three ways or the "estate" is named as the beneficiary, then the IRA funds must be withdrawn on a different schedule, described below as "No Designated Beneficiary." It is very important to correctly name designated beneficiaries to IRAs and retirement plans.

No Designated Beneficiary
If there is no designated beneficiary named in the IRA document, then if the owner was over age 70-1/2 at death, the recipient must withdraw the entire balance of the inherited IRA on the same schedule as applied to the deceased owner, i.e., rated over what would have been the owner's remaining life expectancy. If the deceased owner was not yet age 70-1/2 at death, then the recipient (other than the owner's surviving spouse) must withdraw the entire balance within five years of the deceased owner's death. This is the result if, for example, "the estate" is named as the beneficiary in the IRA beneficiary designation.

Special Opportunity for a Surviving Spouse
If the recipient named in the beneficiary designation is the owner's surviving spouse, the surviving spouse may roll over the remaining balance to his or her own IRA. The surviving spouse then becomes the new owner of the IRA and may delay withdrawals until the April 1st following the year that he or she reaches age 70 1/2. Alternatively, the surviving spouse could treat the account as an "inherited account" and retain the ability to take distributions before attaining the age of 59 1/2 without imposition of the premature withdrawal penalty. The option to roll over the IRA and treat it as if it had originally belonged to the surviving spouse is available only to a surviving spouse.

Non-spouse Beneficiary-Owner Not Age 70 1/2 at Death
If the owner dies before April 1st of the year after turning age 70 1/2, the nonspouse beneficiary can either take minimum distributions over his or her life expectancy, starting no later than December 31st of the year following the owner's death, or receive the entire account balance within five years from December 31st of the year of the owner's death.

Nonspouse Beneficiary-Owner Older Than Age 70 1/2 at Death
If the owner dies after April 1st of the year following turning age 70 1/2 and named a nonspouse as the designated beneficiary, the beneficiary must take minimum distributions over the longer of the beneficiary's life expectancy or the deceased owner's life expectancy at death.