Life insurance proceeds moved to investment account subject to kiddie tax?

[Richard1024]

My client’s son was left a life insurance policy from his dad whom passed away a number of years ago.  The payout of the policy was restricted and remained untouched until age 18.  There was a court order to release the funds from restriction once that age was reached. The funds were then transferred to a money market/investment account.  He is currently a full-time college student, 20 years old and has always been claimed on his mother’s return.  The mother is now remarried and files a joint return where combined income is above $250k.  Son earned income from part-time work while away from college which was under $4k

The question – since this is a life insurance policy from the child’s dad passing away which was transferred to a investment account that pays dividends, interest and capital gains…should kiddie tax factor into the calculation of the return?  The fact that the parent can claim the child, whether or not they actually do, appears to generate the kiddie tax at the parents tax rate for the investment.  Possibly this is assuming it’s the parent that is transferring the funds to the child and therefore the kiddie tax.  Whereas life insurance generally are not taxable.

[Just-Lisa-Now-]

The life insurance was non taxable, the income its earning in the brokerage account IS taxable and unearned income by a dependent may be hit with kiddie tax.  

[BobKamman]

This question should have been asked when the kid turned 18 and he was deciding, with advice from his mother and investment advisers, how to invest the funds.   And, how were the funds invested before he turned 18?  Just sitting there, paying no interest or dividends (which since 2020 might not have been a big issue)?  Anyway, the source of the funds doesn't make a difference.  

His parents likely were divorced when his father died -- that's why he got the insurance, not his mother.  He presumably collected Social Security benefits -- nontaxable -- until he turned 18.  Maybe she did too.  Now it's time to pay back some of the safety net proceeds that are supported by tax dollars, including kiddie-tax assessments.  

[Richard1024]

Thank you very much for the update.  That does make sense that it is now subject to taxes once these decisions were made in moving the funds to investments options versus considering other options or better planning.

[Richard1024]

Thank you very much for the update.  I agree better planning likely would have made a difference.  I’m surprised they didn’t consider any other available options since it’s an advisor that they have used for many years.  Yes, the assumption is correct as it relates to prior years regarding social security being paid to the son until he reached 18.  As for how it was invested prior, that I will need to dig into further as the 1099-R is for 2024 from life insurance (Code 6).

[BobKamman]

So it was not even paid out to him until 2024?  Are you sure this was life insurance, and not an annuity sold by a life insurance company?  The 1099-R isn't used for life insurance payouts.  Does it show all of the distribution is taxable?  

[Richard1024]

As I was inquiring about the child’s investment account, that's when the history of the life insurance came up and communications provided that this was released from restriction (which would have been 2022).  However, you’re right the 2024 1099-R is probably not related.  The 1099-R is from an insurance company in the parent’s name in 2024.  My initial thought, possibly the funds were released earlier in 2022 to the account from where 1099-R was eventually distributed in 2024.  I will discuss further with the client for additional clarity…specifically what happened with the funds during the gap period between 18 and 20 years old.  Where were the funds during the period as this was the first year that I was provided with an investment statement for the child.