The tax difference between leaving heirs life insurance or an IRA

A $500,000 life insurance death benefit and a $500,000 traditional IRA look identical on a net worth statement, but they are not worth the same to the person who inherits them. The death benefit is generally income-tax-free to the beneficiary. The IRA is not: every dollar an heir withdraws from an inherited traditional IRA is generally taxed as ordinary income. That gap, which can run to six figures, is the reason the order in which a retired person spends money matters to the family left behind.

This post compares the two, side by side, with round illustrative numbers. It is general information, not tax advice. Your own brackets, your state's rules and the exact type of IRA all change the answer, and a CPA or estate attorney is the right person to run your figures.

How each one is taxed when an heir receives it

The two assets follow different parts of the tax code, which is why they behave differently.

Two points in that table deserve more explanation.

The death benefit. The rule that a death benefit is excluded from the beneficiary's income is one of the most stable features of life insurance law, and is life insurance taxable? covers it with the exceptions: interest the insurer adds, a policy sold for value, and gains taken out of cash value while the owner is alive. A prompt lump sum has no income tax attached to it for a person who simply inherits it.

The traditional IRA. The contributions to a traditional IRA were generally deducted, and the growth has never been taxed. The tax bill is simply deferred until money comes out. When the owner dies, the tax obligation does not disappear; it transfers to the beneficiary along with the money. An heir does not receive the "stepped-up basis" that inherited stocks or real estate generally get, because there is no basis to step up in a pre-tax account. This is the single biggest reason a $500,000 IRA is worth less than $500,000 to a child.

The emptying deadline

Since the SECURE Act of 2019, most beneficiaries other than a surviving spouse must withdraw the entire inherited account by the end of the tenth year after the owner's death. Some beneficiaries are treated differently, including a surviving spouse, the owner's minor child (until the age of majority), a beneficiary who is disabled or chronically ill, and one who is not more than ten years younger than the owner. Whether annual withdrawals are also required inside those ten years depends on whether the owner had already reached the age for required minimum distributions. The details have been the subject of IRS guidance and transition relief, so ask a tax professional what applies to a specific account, and see the IRS publication on retirement plan distributions (Publication 590-B).

The practical effect is that a child inheriting a traditional IRA cannot usually leave the money to grow indefinitely, and a large balance can push income into higher brackets during the years the withdrawals are taken. A death benefit has no such clock.

A worked comparison with round numbers

Say a widowed parent dies leaving two accounts that happen to be the same size, and two adult children who will split everything equally. These numbers are an illustration, not a forecast.

• A permanent life insurance policy with a $500,000 death benefit, payable to the children.
• A traditional IRA with a $500,000 balance, payable to the children.

The children must withdraw the IRA over ten years. To keep the arithmetic clean, assume the withdrawals are taxed at a single combined federal and state rate, which differs by child. In real life the rate would change year to year with each child's other income, so treat each row as an average.

The arithmetic is just $500,000 times the rate for the tax and $500,000 minus that for what the heir keeps. If the heir inherits a Roth IRA instead, and the Roth rules are met, the row would look like the death benefit: $500,000 kept.

Three things could shift these numbers.

1. Timing. Spreading withdrawals across ten years can help if the heir has a low-income year, and hurt if the heir is at peak earnings. A person who inherits at 45, in the highest-earning decade, is often in a worse position than one who inherits at 70 in retirement.
2. Growth. An IRA can keep growing between the death and the final withdrawal, which adds taxable income. A death benefit is paid once.
3. The cost of getting the insurance. The comparison above starts after the policy exists. Someone had to pay premiums, and that cost is a real difference. Whether insurance was worth buying is a separate question; this post is about two assets that already exist.

The estate tax is a separate layer

Everything above concerns income tax on the heir. The federal estate tax is a separate system, and the two assets are treated alike in one respect: both can be pulled into the estate of the person who died.

The IRA is part of the owner's gross estate. A life insurance death benefit is included if the insured owned the policy (or held other "incidents of ownership") at death, or if it is payable to the estate. life insurance and the federal estate tax explains both triggers. The basic exclusion for 2026 is $15,000,000 per person, according to the IRS, so most families owe no federal estate tax at all, and the figure can be doubled for a married couple through portability when the return is filed. For the small minority whose estates are larger, a policy owned by an irrevocable trust rather than the insured is the usual way to keep the death benefit out of the taxable estate. An IRA cannot be moved into a trust during the owner's life without being cashed out and taxed, so it stays in the estate.

Some states levy their own estate or inheritance taxes at much lower thresholds. Check your state's rules if your estate is anywhere near them, and use the estate tax exposure check to see where you stand against the federal figure.

What this means for which to spend first

People in retirement often ask whether to draw down the IRA or keep it, and whether to hold the life insurance for the family or let it go. The answer depends largely on one comparison: the parent's tax rate on a withdrawal now against the heir's expected rate on the same money later.

Here is the arithmetic for a parent who needs $30,000 after tax this year, for a home repair. The parent is considering taking it from the traditional IRA, or from a taxable savings account. For the illustration, assume the savings account money would pass to the heir with no tax due (its gains, if any, would generally get a stepped-up basis).

The pretax figures come from dividing $30,000 by one minus the parent's rate: $30,000 divided by 0.88 is $34,091 and $30,000 divided by 0.68 is $44,118. The heir's value is the withdrawal times one minus the heir's rate: $34,091 times 0.68 is about $23,200, and $44,118 times 0.88 is about $38,800.

In Case A the parent pays a lower rate than the heir would, so using the IRA first costs the family less than using the savings. In Case B the reverse holds, and using the savings first leaves the heirs better off. Real households sit in between, and other factors matter: required distributions that begin at age 73 for many people (rising to 75 for those born in 1960 or later), Medicare premium surcharges tied to income, and the state tax in both the parent's and the heir's state.

This kind of arithmetic is why some planners suggest drawing on pre-tax accounts first when the parent's bracket is low and leaving insurance and Roth money for last. Others point out that the same logic can argue for Roth conversions, which move tax to the parent now at the parent's rate. Neither is a rule. See life insurance in retirement: keep, cut or cash out for how insurance fits into a retirement plan more broadly, and retirement legacy planning: using a policy to treat heirs fairly for the question of treating several children fairly when the assets are different kinds.

Should the policy be kept?

A paid-up or fully funded permanent life insurance policy that will pass tax-free is often the last asset a retiree touches. A policy that is expensive to maintain, or that the parent no longer needs, is a different question, and the answer turns on the cost of keeping it, the cash value, and what else the family has. Surrendering a permanent policy can create taxable gain above the cost basis the owner paid in premiums. Dropping a term policy at expiry is a different case, with no value to recover.

The IRA-to-insurance idea, with the case on both sides

You will sometimes see a pitch that retirees should withdraw from an IRA, pay the tax, and use the net money to buy permanent life insurance, so heirs get a tax-free benefit instead of a taxable account. It is a legitimate planning question and also a contested one.

The case for it. If the IRA would otherwise be taxed to heirs at a higher rate than the parent pays now, paying the tax at the lower rate and converting the money into a death benefit can increase what the family receives. Insurance also offers a guaranteed amount at death in a way an investment account does not, and it is not subject to the ten-year emptying rule. For a person whose IRA is large and not needed for spending, this can be a sensible use.

The case against it. The parent pays the tax immediately, the premium money is no longer available for the parent's own needs, and the policy has its own costs that reduce the return compared with leaving the money invested. The insurer must be willing to cover the person, which depends on age and health, and a policy bought late in life can be expensive. The projected results come from illustrations that rely on non-guaranteed assumptions, and the tax advantage disappears if the policy lapses or is surrendered in the early years. A person who may need the IRA for long-term care or living costs may regret having spent it.

Because the numbers depend heavily on age, health, tax bracket and the specific policy, treat any proposal of this kind as something to test with a fee-only planner or CPA who does not earn a commission on the policy, and ask for guaranteed values as well as the projected ones.

Naming the beneficiaries correctly

Both assets pass by beneficiary designation, outside the will, which means the form on file with the insurer or the IRA custodian controls. A will that says something different does not change it. Check these points on each:

• A named primary and contingent beneficiary on each. If the primary dies first and no contingent is named, the money often goes to the estate, which adds probate and, for an IRA, can shorten the time to empty the account.
• A trust as beneficiary needs care. Naming a trust for an IRA can affect how fast the account must be emptied and how it is taxed along the way. naming a trust as your life insurance beneficiary explains the idea for insurance; for IRAs the drafting is specialized, and an estate attorney should write it.
• A spouse has options an adult child does not. A surviving spouse can generally treat an inherited IRA as their own, which is a major reason spouses are usually named first.
• Review after life events. Divorces, deaths and new grandchildren all change who should be on the forms.

The retirement account and the policy are often managed by different people at different institutions, so the forms get out of step. A single sheet that lists every account, the custodian, the beneficiary and the date of the last review prevents most of the problems.

Questions to take to a CPA or estate attorney

1. If I die this year, what would each of my children owe on the inherited IRA, given their current income?
2. Is a Roth conversion worth considering at my bracket, and what would it do to my other taxes?
3. Is my life insurance owned in a way that includes it in my taxable estate?
4. Which should I spend first in retirement, and does that change if one of my heirs is in a much higher bracket than I am?
5. Do my beneficiary forms match the plan I described, and is there a contingent on each?
6. If I own a permanent policy I no longer need, what would surrendering it cost me in tax?

Key takeaways

• A death benefit is generally income-tax-free to the beneficiary; an inherited traditional IRA is taxed as ordinary income when withdrawn, so equal balances are not equal inheritances.
• Most non-spouse heirs must empty an inherited IRA within about ten years, while a death benefit has no clock, so the IRA can push an heir into higher brackets.
• Whether to spend the IRA or other assets first often turns on the parent's rate against the heir's rate, and the arithmetic can point in either direction.
• Both assets can be part of the taxable estate, though the 2026 federal exclusion of $15,000,000 per person means most families owe no federal estate tax.
• Check that beneficiary forms are current, and test any plan to swap IRA money for insurance with a professional who is not paid by commission.