Iras And Life Insurance: What's Included In An Estate?

Life insurance and retirement accounts can be part of an estate, but it depends on how they are handled when the original owner is still alive. When someone opens a retirement account, part of the paperwork includes naming one or more beneficiaries who will inherit the account when the owner dies. If the owner fails to name a beneficiary, the account will be subject to probate. However, if a beneficiary is named, the account will not form part of the estate and will be transferred directly to the beneficiary. Similarly, life insurance can be used to support one's legacy and ensure loved ones are taken care of after death. However, if the insurance policy is owned by the estate, it will be subject to heavy taxation, which can limit how much money goes to your loved ones. To avoid this, it is recommended that the policy be owned by a separate entity, generally a trust.

Naming your estate as your beneficiary

The Probate Process

If you designate your estate as a beneficiary, the assets will have to pass through probate court and be subject to a lengthy and costly legal process that is open to public scrutiny. Probate increases the possibility that your assets won't be distributed according to your specific wishes.

Tax Implications

Leaving items to your estate also increases the estate's value, and it could subject your heirs to exceptionally high estate taxes.

Loss of Planning Options

Naming your estate as beneficiary may also sacrifice some planning options and potentially expose the retirement funds to extra fees, risks, and creditors.

Naming a Beneficiary

It's important to keep your beneficiary designations up to date as your life changes (marriage, children, divorce, etc.).

Your beneficiary can be a person, a charity, a trust, or your estate.

Almost any person can be named as a beneficiary, although your state of residence or the provider of your benefits may restrict who you can name. Make sure you research your state’s laws before naming your beneficiary. If you are a resident of certain states, you may be required to list your spouse as your primary beneficiary and designate them to receive at least 50% of the benefit. In some states, you can name someone else with your spouse’s written permission.

Your beneficiary designation can be done by filling out a web form provided online by the company holding the asset. Most companies will ask you to name a beneficiary when you first open the account.

Primary and Contingent Beneficiaries

There are two types of beneficiaries: primary and contingent. A primary beneficiary is the person (or persons) first in line to receive the death benefit from your life insurance policy. In the event your primary beneficiary dies before or at the same time as you, most policies also allow you to name at least one backup beneficiary, called a “secondary” or “contingent” beneficiary. If the primary beneficiaries are all deceased, the secondary beneficiaries receive the death benefit.

Probate and how to avoid it

Probate is a legal procedure where a court oversees the distribution of a person's property upon their death. It is a common part of estate planning, even if the deceased has left a will. However, probate can be time-consuming, expensive, and stressful, and it can delay the distribution of assets to loved ones. Here are some ways to avoid probate:

• Give away property: Gifting or transferring property before your death removes it from probate because you no longer have ownership of it. While this can be part of your estate plan, it is important to note that you will no longer have use of the property, and if the gift exceeds a certain amount, federal gift tax may apply.
• Establish joint ownership: Joint ownership with right of survivorship allows property to pass directly to the surviving owner without probate. This can apply to real estate, motor vehicles, boats, financial accounts, and securities.
• Leverage payable-on-death financial accounts: Designating a beneficiary for financial accounts such as bank accounts, IRAs, or 401(k)s allows the funds to be paid directly to that person without probate.
• Use transfer-on-death securities: Transfer-on-death (TOD) allows you to designate a beneficiary and specify the percentage of assets they will receive, bypassing probate. This can be used for government bonds, mutual funds, stocks, brokerage accounts, and other security-related holdings.
• Use transfer-on-death for motor vehicles: Some US states allow you to name a TOD beneficiary for the transfer of motor vehicles, such as cars, trucks, and small boats.
• Use transfer-on-death for real estate: Some states allow real estate investments to escape probate through the execution and recording of a TOD deed, where ownership passes to the beneficiary upon your death, but you retain full control during your lifetime.
• Create living trusts: A living trust, commonly called a revocable living trust, allows the trust to own the assets instead of the individual, thereby skipping probate. This is a common method for people with high-value estates and ensures privacy.
• Take advantage of small estate provisions in the law: Many states have simplified or expedited probate procedures for small estates, which often have different definitions of "small estate" value.

Additionally, having a clear and updated will in place before your passing can help guide the distribution of your assets and make the probate process less lengthy and complicated.

Trusts and beneficiaries

Choosing the Right Beneficiaries

It is crucial to select the appropriate beneficiaries to avoid confusion and minimise taxation. While you may be tempted to name your estate as the beneficiary of your IRA or life insurance policy, this is generally the worst option in terms of tax implications and planning flexibility. Instead, consider naming a spouse, child, or other individuals, or a qualifying trust as the beneficiary, as they will have more favourable post-death distribution options.

Advantages of Naming Individuals or Trusts as Beneficiaries

Naming individuals or qualifying trusts as beneficiaries provides more favourable post-death distribution options. These beneficiaries can take required distributions over a longer period, typically based on their remaining life expectancy. This helps spread out the income tax bill and prolongs tax-deferred growth. Additionally, naming a qualifying trust as the beneficiary can provide greater control over how and when assets are distributed to the trust beneficiaries.

Disadvantages of Having Your Estate as the Beneficiary

If your estate is the beneficiary of your IRA or life insurance policy, you will likely face limited and unfavourable post-death distribution options. The required distributions will have to be made at the fastest rate possible, potentially increasing the income tax liability. Additionally, the funds will have to pass through probate, a costly and time-consuming court-supervised process that may expose the funds to creditors.

Using Trusts to Own Life Insurance Policies

To avoid estate tax liability issues and the probate process, consider having an irrevocable trust own your life insurance policy. This arrangement ensures that the death benefit is not taxed as part of your individual estate. One type of trust used for this purpose is an irrevocable life insurance trust (ILIT), which allows you to make gifts to the trust and purchase life insurance using your annual gift exclusion.

Important Considerations for Trusts and Beneficiaries

When setting up a trust or naming beneficiaries, it is essential to seek professional advice from a qualified estate planning attorney or financial advisor. They can guide you through the complex tax and legal implications and help structure your estate plan to align with your wishes and goals.

Taxation on life insurance proceeds

Life insurance payouts are generally not subject to income taxes or estate taxes. However, there are certain exceptions. The type of policy, the size of the estate, and how the benefit is paid out can determine if life insurance proceeds are taxed.

If the life insurance policy goes into an estate, the proceeds may be taxed. This can happen if the policy has no named beneficiaries, in which case, the proceeds may be included in the deceased's estate. If the value of the estate exceeds the federal estate tax threshold, which was $13.61 million as of 2024, estate taxes must be paid on the amount over the limit. Some states also assess inheritance or estate taxes, depending on the estate's value and location.

If the beneficiary chooses to receive their payout as an annuity (a series of payments over several years) instead of a lump sum, any interest accrued by the annuity account may be subject to taxes.

If you withdraw or take out a loan against your whole life policy's cash value, you may have to pay income taxes on the excess if you withdraw more than your cumulative premium payments. Likewise, if you borrow against the cash value and the loan is still outstanding when the policy is terminated or surrendered, the loan amount in excess of the cumulative premiums may be subject to income taxes.

If you surrender your whole life insurance policy, you can exchange it for a cash payment from the insurance company. If the surrender proceeds exceed the cumulative premiums, the excess may be subject to income taxes. However, if the surrender value is less than the cumulative premiums paid, you likely won't pay income taxes on the cash payment.

If you sell your whole life policy to a third party, the sales proceeds may be subject to income taxes if they exceed your cumulative premiums, minus the portion attributed to the cost of insurance.

Some life insurance companies offer dividends to whole life insurance policyholders, which are generally not taxed. However, if you let the insurer keep your dividends in exchange for interest, you may pay income tax on the interest.

Additionally, if you have employer-paid group life insurance, it may be taxable. According to the IRS, if the death benefit is greater than $50,000, the employer-paid premiums for coverage over $50,000 are subject to income taxes.

To avoid taxation on life insurance proceeds, it is recommended to transfer ownership of the policy to a separate entity, such as an irrevocable trust. This helps to remove the proceeds from your taxable estate and can provide greater control over the policy. It is important to note that the three-year rule applies to ownership transfers, where gifts of life insurance policies made within three years of death are still subject to federal estate tax.

Retirement accounts and probate

Retirement accounts can be protected from the probate process by designating beneficiaries properly. This includes individual retirement accounts (IRAs), 401(k)s, 403(b)s, and several other less common types of retirement accounts. When someone opens a retirement account, they are usually required to name one or more beneficiaries who will inherit the account when the owner dies.

The financial institutions where the accounts are held must hand over those assets to the named beneficiaries upon the owner's death. The contract between the account holder and the custodian takes the place of the will for these assets, keeping them out of probate. In this situation, creditors cannot collect debts from the accounts.

However, there are several ways that retirement accounts can end up in probate, usually as a result of a mistake in the beneficiary designation. For example, not naming a spouse as a beneficiary in community property states, naming a trust or the estate as a beneficiary, or naming a minor as a beneficiary without designating someone to manage the assets for them.

If there are no beneficiaries named on the account, or if all named beneficiaries have died, the retirement account will be subject to probate. In this case, the money in the account is first distributed to the estate and then passed to the heirs according to the terms of the will. This option often results in unfavourable tax implications and limits planning options.

To avoid probate, it is important to designate beneficiaries carefully and review the designations regularly, especially after major life changes.

Frequently asked questions