Life Insurance Benefits: Probate Or Not?

Life insurance can be a great way to support your family after your death, but it's important to understand how it fits into your estate planning. In most cases, life insurance benefits do not go through probate as the money in a life insurance policy is not considered part of your estate. Instead, the insurance company holds the policy amount in trust for the beneficiaries, who receive the money directly upon the death of the policyholder. However, there are certain scenarios where life insurance may go through probate, such as when the beneficiary predeceases the policyholder or when the policy is payable to the insured's estate. Understanding how life insurance interacts with probate can help ensure that your wishes are carried out and that your loved ones are provided for.

Life insurance policies with no named beneficiaries

If there are no named beneficiaries on a life insurance policy, the death benefit is paid out to the deceased's estate. This means that the money will be distributed according to their will, along with any other assets. If there is no will, the funds will be paid into the estate of the policyholder and distributed by the courts.

If the deceased left a surviving spouse, children or family, these people are considered "next of kin" and will generally inherit the entire estate. However, if there are any outstanding debts, creditors can claim the payout.

It is possible to have multiple beneficiaries and leave a percentage of the payout to each. For example, you could leave 40% to your spouse and 20% to each of your three children.

It is important to keep your beneficiaries up-to-date. If your primary beneficiary has passed away, your contingent beneficiary will be entitled to the money. If there is no contingent beneficiary, the money will usually be paid into the estate of the person who has died and then distributed to any surviving family members.

Life insurance beneficiaries who are deceased

If the primary beneficiary of a life insurance policy dies before the policyholder, the death benefit will go to any contingent beneficiaries named when the policy was applied for. If no contingent beneficiaries were named, the death benefit will likely go directly into the policyholder's estate.

If one of multiple primary beneficiaries dies, the remaining beneficiaries will receive the death benefit. Typically, they would each receive the same amount of money, but the policyholder can request a different type of distribution if they wish.

If the contingent beneficiary dies and the primary beneficiary is also deceased, any remaining beneficiaries will receive the payout. If there are no remaining beneficiaries, the death benefit will likely be paid to the policyholder's estate, which can lead to probate and potential delays.

To avoid this, it is important to keep beneficiary designations up to date. Policyholders should regularly review and update their policies and beneficiaries to ensure their life insurance reflects their current wishes and the needs of those who depend on them.

Life insurance proceeds and estate taxes

Life insurance proceeds 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.

The cash value of a life insurance policy purchased and owned by the deceased is included in their taxable estate and is subject to state and federal estate taxes. The federal estate tax exemption was $12.06 million in 2022 and $12.92 million in 2023. If an individual's estate surpasses this exemption, they may have to pay estate taxes.

There are ways to ensure that life insurance benefits are not included in one's estate, so they are not subject to state or federal estate tax. According to estate tax rules, insurance on one's life will be included in their taxable estate if:

• Their estate is the beneficiary of the insurance proceeds.
• They possessed certain economic ownership rights, known as "incidents of ownership," in the policy at their death or within three years of their death.

One way to avoid estate taxes is by transferring ownership of the life insurance policy to another person or entity. This involves choosing a competent adult or entity as the new owner, obtaining the proper assignment or transfer of ownership forms from the insurance company, and having the new owner pay the policy premiums. It is important to note that the original owner will give up all rights to make changes to the policy in the future.

Another way to remove life insurance proceeds from the taxable estate is to create an irrevocable life insurance trust (ILIT). The policy is typically transferred to the trust along with assets that can be used to pay future premiums, or the trust buys the insurance itself with funds contributed by the insured. As long as the trust agreement does not give the insured any ownership rights, the proceeds will not be included in their estate.

Avoiding probate through beneficiary designations

Designating a beneficiary is a quick and cost-effective way to transfer assets and avoid probate. When a person passes away, an asset with a designated beneficiary will pass outside of probate and go directly to the named heir, regardless of the terms of the will. The beneficiary can then inherit the proceeds of the account without involving the court.

However, there are instances where a loved one is intended to inherit an asset, but designating them as a beneficiary is not advantageous. For example, a minor should not be named as a beneficiary. While naming a minor as a beneficiary can avoid probate, the cost of collecting the asset for them could be significant. If a minor receives money (over a certain amount), a petition for guardianship of the property must be filed with the court. The court will then be involved until the child reaches the age of majority.

Similarly, if a loved one has special needs and is receiving needs-based government benefits, their share of the inheritance could make them ineligible to continue receiving those benefits. In this case, it may be more sensible to use estate planning trusts.

It is important to consult with an experienced estate planning attorney or probate attorney to ensure that your wishes are carried out. Before determining heirs, it is recommended to seek legal advice to tailor a long-term care protection plan.

There are several issues to consider when making beneficiary designations:

• Cash is king: Ensure that enough money comes into your estate so that your executor can pay any cash gifts left in your will to individuals or charities.
• Cover your estate tax liability: If assets pass outside your estate to a named beneficiary, make sure there will be sufficient funds in your estate and trust to pay your estate tax liability.
• Protect your tax savings: If you have created trusts for estate tax purposes, ensure that enough assets flow into your trusts to maximize tax savings. Naming individuals as beneficiaries instead of trusts may defeat the purpose of your estate tax planning.
• Precision matters: Ensure that all information on the change of beneficiary form is correct, especially if the beneficiary is a trust. Don't guess—if you are unsure about any details, consult your lawyer.
• Spouses as beneficiaries: It is common to name a spouse as the primary beneficiary of a life insurance policy, but this may defeat your estate planning, especially if you have children from a previous marriage or if you do not want your spouse to control the assets.
• Avoid last-minute changes: Last-minute changes to beneficiary designations due to nerves or illness may lead to increased estate tax payments and litigation from heirs who were cut out.
• Be careful with qualified accounts: Do not name a trust as the beneficiary of a qualified account, such as an IRA, without first consulting an attorney. Trusts that receive such qualified money need to contain special provisions for income tax purposes.

Life insurance and estate planning

Life Insurance and Probate

In most cases, life insurance proceeds do not go through probate. This is because the money in a life insurance policy is not considered part of your estate and typically never becomes an asset of the policyholder. Instead, the insurance company holds the policy amount in trust for the beneficiaries, who receive the payout directly upon the policyholder's death. Avoiding probate is beneficial as it is a lengthy, costly, and unpredictable process.

However, there are certain scenarios where life insurance may go through probate:

• If the beneficiary predeceases the policyholder and no alternate beneficiary is named, the proceeds will be paid to the policyholder's estate.
• If the policy is made payable to the insured's estate, it will be distributed according to the will or state laws.

Strategies for Effective Estate Planning:

To ensure your life insurance supports your estate wishes and minimizes taxation and legal complexities, consider the following strategies:

• Remove Life Insurance from Your Estate: It is advisable to separate your life insurance policy from your estate by transferring ownership to a trust, preferably an irrevocable trust. This helps avoid estate taxes, which can significantly reduce the funds available to support your loved ones.
• Choose the Right Type of Trust: An irrevocable life insurance trust allows you to make gifts to the trust and purchase life insurance using your annual gift exclusion. This way, you can leverage your gifts by purchasing a life insurance contract within the trust, ensuring the death benefit is not taxed as part of your estate.
• Spousal Lifetime Access Trusts (SLATs): SLATs are sophisticated techniques that utilize the sale of assets and gifts. The SLAT can absorb the lifetime exemption and use the gifted assets to pay premiums on a life insurance contract, increasing the value of the trust.
• Choose Beneficiaries Wisely: Selecting the right beneficiaries is crucial. In some cases, naming a trust as the beneficiary may trigger taxation. It is generally advisable to name your spouse as the owner and beneficiary of the policy, with you as the insured. This helps ensure assets are passed on to your family without incurring heavy taxes.
• Update Beneficiary Designations: Keep your beneficiary designations up to date, especially after major life events like marriage, divorce, or the death of a loved one. Failing to update beneficiaries can result in the policy proceeds going through probate or unintended recipients receiving the payout.
• Contingent Beneficiaries: Naming a contingent or alternate beneficiary reduces the likelihood of the policy going through probate due to the unavailability of the intended beneficiary.

In conclusion, life insurance can play a crucial role in estate planning by providing financial security for your loved ones and supporting your legacy. By understanding how life insurance interacts with probate and implementing effective estate planning strategies, you can maximize the impact of your assets and ensure your wishes are carried out according to your intentions.

Frequently asked questions