Life Insurance Benefits: Estate Inclusion Or Exclusion?

Life insurance can be a valuable asset for beneficiaries, offering financial security and helping them avoid hardship. However, the process of distributing these benefits can be complex and depends on several factors. In most cases, life insurance proceeds are paid directly to the named beneficiaries, bypassing the estate and probate process. However, if there are no named beneficiaries or if the beneficiaries die before the insured person, the proceeds may become part of the estate assets. In such cases, the distribution of the death benefit will follow the instructions in the will or state laws, and may be subject to taxes and used to pay off debts. To avoid potential issues, it is essential to keep beneficiary designations up to date and consider consulting an estate planning attorney or financial advisor.

Naming 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 the life insurance policy. Typically, this is a spouse, child, or other family member. A contingent beneficiary is a backup person who will receive the death benefit if the primary beneficiary dies before or at the same time as the policyholder.

You can name as many beneficiaries as you want and choose how much of the death benefit each will receive. You can also specify whether the beneficiary should receive the proceeds as a lump sum or in monthly payments. It is important to keep your beneficiary designations up to date, especially after major life changes such as marriage, divorce, or the birth or adoption of a child.

If you do not name a beneficiary, the death benefit will automatically be paid to your estate and will be distributed according to the instructions in your will or per state laws. This can delay the payment of benefits and reduce the amount available to your heirs due to court costs and taxes.

To name a beneficiary, you will need to fill out a beneficiary designation form provided by the life insurance company. This form will require the beneficiary's full legal name, their relationship to you, and their social security number.

Probate and distribution

Probate is a legal process that verifies the will of a deceased individual. During probate, an executor is appointed to manage the distribution of the deceased's estate. The executor is responsible for dealing with the assets and liabilities of the deceased according to their wishes. In some jurisdictions, such as Ontario, the executor must be confirmed through the probate process.

Life insurance proceeds are typically distributed directly to the named beneficiaries outside of the probate process. This allows beneficiaries to receive the death benefit quickly, usually within a month or so. However, if there are no named beneficiaries or if the beneficiaries die before the insured person, the proceeds may become part of the estate assets.

When life insurance proceeds become part of the estate, they are treated as additional assets. These proceeds can be used to pay off any debts, taxes, and fees associated with the estate. The remaining amount is then distributed according to the instructions in the will or, in the absence of a will, per state laws or relevant succession laws.

To avoid probate and ensure a quick distribution of the death benefit, it is essential to keep beneficiary designations up to date. Designating beneficiaries directly on the life insurance policy can help streamline the process and prevent the proceeds from becoming part of the estate.

Estate taxes and fees

Estate taxes are incurred on the transfer of the estate of a person who has died. The estate tax is a federal tax, but 12 states also tax the estate of the deceased, and six states levy an inheritance tax on the beneficiary of the estate.

The estate tax is imposed on the fair market value of the estate, not on the price paid by the deceased. The gross estate includes cash and securities, real estate, insurance, trusts, annuities, business interests, and other assets. Deductions are then made to arrive at the taxable estate. These deductions may include mortgages and other debts, estate administration expenses, property that passes to surviving spouses, and qualified charities.

The federal estate tax applies to estates worth at least $13.6 million as of the 2024 tax year. This amount is periodically revised, and it is expected to rise to $13.66 million in 2025. Surviving spouses are generally exempt from federal estate taxes.

In addition to federal estate taxes, life insurance proceeds may also be subject to state estate taxes or inheritance taxes, depending on the state where the deceased lived or the beneficiary resides. These taxes typically have lower thresholds than federal estate taxes, with the lowest being $1 million.

To minimize estate taxes, taxpayers can set up trusts, transfer ownership of their life insurance policies, or utilize other strategies with the help of a professional tax consultant.

Irrevocable life insurance trusts

ILITs are particularly useful for affluent families with sizable estates, as they can help reduce the tax burden. They are also beneficial for those with loved ones who have special needs, as they can set aside assets for their care without interfering with their eligibility for government benefits.

There are three parties involved in an ILIT: the grantor (who creates and funds the trust), the trustee (who manages the trust and pays insurance premiums), and the beneficiary/beneficiaries (who receive the trust assets upon the grantor's death).

One of the key advantages of ILITs is their ability to minimise estate taxes. When a life insurance policy is owned by an ILIT, the proceeds from the death benefit are not considered part of the insured's gross estate and are therefore not subject to state and federal estate taxation.

ILITs also offer protection from gift taxes, as contributions by the grantor are considered gifts to the beneficiaries. Additionally, they can help protect government benefits for beneficiaries receiving aid, such as Social Security disability income or Medicaid. The trustee can control how distributions from the trust are used to ensure continued eligibility for these benefits.

The primary downside of ILITs is that they are irrevocable, meaning they cannot be easily modified or terminated once established. Any changes to the trust typically require legal action or the consent of the beneficiaries.

Beneficiary designations

Designating a beneficiary is a crucial step in purchasing a life insurance policy. A life insurance beneficiary is the person or entity you name to receive the death benefit from the policy. This could be one or more persons, a trustee of a trust you establish, a charity, or your estate.

There are two types of life insurance beneficiaries: primary and contingent. The primary beneficiary is the first in line to receive the death benefit, while the contingent beneficiary receives the benefit if the primary beneficiary is unavailable or deceased.

When choosing a life insurance beneficiary, it is essential to consider your personal situation and who will need financial support after your death. You may also want to consider setting up a trust, especially if you want to provide for minor children or other dependents who cannot directly receive the benefit.

It is important to keep your beneficiary designations up to date, as life changes such as marriage, divorce, or the birth of a child may impact your choices. Most policies allow you to change your beneficiaries at any time, but it is your responsibility to ensure that these changes are made.

In some cases, your state of residence or insurance provider may restrict who you can name as a beneficiary. For example, in community property states, your spouse may be automatically entitled to a portion of the death benefits. Similarly, if you are married, your spouse may have to sign a waiver before you can name someone else as the beneficiary.

If you do not name a beneficiary, the death benefit will typically be paid to the owner of the policy if they are different from the insured person and still alive, or to the owner's estate. For group insurance policies, the order usually starts with the spouse, followed by children, then parents, and finally, the estate.

To ensure your wishes are carried out, it is crucial to designate a beneficiary for your life insurance policy and keep this information up to date. By doing so, you can provide financial support and security for your loved ones after your death.

Frequently asked questions