Life Insurance: Estate Asset?

Life insurance is a crucial component of estate planning, but it can be challenging to determine whether it is considered part of an estate. The answer depends on various factors, such as the presence of a beneficiary, the type of beneficiary, and the applicable laws. Typically, life insurance proceeds bypass the estate and go directly to the named beneficiaries. However, if there are no beneficiaries or if the beneficiaries have predeceased the policyholder, the proceeds may become part of the estate assets.

Life insurance proceeds usually go directly to named beneficiaries

The only exception is when the insurance policy is payable to "your estate" or when the named beneficiary dies before you. Without a living beneficiary, the life insurance funds will be considered part of your estate, similar to a bank account you owned.

There are two types of beneficiaries: primary and contingent. A primary beneficiary is your first choice to receive the death benefit, while a contingent beneficiary will receive the death benefit if the primary beneficiary dies before you. You can also have multiple beneficiaries and choose how much of the payout each party receives.

It's important to be specific when designating a beneficiary to avoid disputes. For example, just saying "husband" or "wife" can cause problems if you get divorced and remarried. For a person, you'll want to include the following details:

• Address
• Social Security Number
• Date of birth

You can also specify whether a beneficiary should receive the life insurance proceeds as a lump sum payment or in monthly payments.

If your intended beneficiary is a minor, some insurers won't let you directly name them as a beneficiary. In these cases, you can name their legal guardian or custodian, or create a trust for the child and make the trust the beneficiary.

Life insurance proceeds that go directly to beneficiaries are usually not considered taxable income. However, if the proceeds go to the estate, they may be subject to estate tax if the estate exceeds certain thresholds.

If there are no beneficiaries, the proceeds may become part of the estate assets

Life insurance is usually paid directly to the named beneficiaries, bypassing the estate and probate process. However, if there are no beneficiaries, the proceeds may become part of the estate assets.

In the absence of beneficiaries, the life insurance proceeds will be paid to the probate estate, where they will be used to cover any remaining bills and costs. The remainder of the death benefit will then be passed down to the living heirs-at-law of the policyholder, or distributed according to the will or state laws if there is no will. Heirs-at-law are close relations with a legal entitlement to the deceased's assets if they died without a will.

The death benefit will be considered part of the estate for tax purposes, and may be subject to federal and state estate taxes. The estate may also be liable for income tax on the portion of the tax year when the deceased was alive. In addition, the death benefit may be used to pay off any remaining debts of the deceased, including estate taxes, before the remaining assets are distributed to the heirs.

To avoid the death benefit becoming part of the estate, policyholders should regularly review and update their primary and contingent beneficiaries.

Life insurance proceeds are considered part of an estate for tax purposes

Life insurance is a valuable tool for estate planning. It can provide much-needed financial support to your loved ones after your death, allowing them to avoid financial hardship and pursue essential goals. However, understanding how life insurance interacts with your estate can be complex.

Life insurance proceeds typically go directly to the named beneficiaries, bypassing the estate and probate process. This direct transfer ensures that the funds are protected from creditors and leftover debt on the estate. However, if there are no named beneficiaries or if the named beneficiaries have predeceased the policyholder, the proceeds may become part of the estate assets.

When life insurance proceeds become part of the estate, they are treated as additional assets. This can increase the value of the estate, potentially triggering federal or state estate taxes if it exceeds certain thresholds. In 2024, the federal estate tax exemption is $13.61 million, and rates for estate taxes can vary from 18% to 40%.

To avoid having life insurance proceeds become part of your estate, it is essential to keep your beneficiary designations up to date. You can also consider putting your life insurance into a trust, which gives you more control over how the proceeds are used and can help reduce estate tax burdens.

It is important to note that life insurance proceeds paid to beneficiaries are not considered income for tax purposes. However, as an owner of the policy, the entire amount of the benefit paid out will be included in your gross estate value for estate tax purposes. Therefore, careful planning is necessary to minimize the tax burden on your beneficiaries.

Life insurance can be used to provide funds for the payment of estate taxes

In the US, the federal estate tax exemption is $13.61 million as of 2024. If your estate is worth more than this amount, it will be taxed at a rate of up to 40%. Additionally, 17 states and Washington, D.C., have their own estate or inheritance taxes, with thresholds ranging from $1 million to $7 million.

To avoid having life insurance proceeds count towards the value of your estate, you can set up an irrevocable life insurance trust (ILIT). The trust owns the policy, and you are the insured. This way, you benefit from the protection of the insurance without it being included in your estate value. However, it's important to note that the three-year rule applies to ILITs—if you die within three years of setting up the trust, the proceeds will be included in your estate.

Another option is to transfer ownership of the life insurance policy to another person or entity. This requires careful consideration, as the new owner will have certain rights and responsibilities, such as paying premiums. It's also important to note that if you transfer ownership within three years of your death, the proceeds will likely be included in the value of your estate.

Consulting a financial advisor or estate planning attorney can help you navigate the complexities of life insurance and estate planning to ensure that your wishes are carried out and your loved ones are provided for.

Life insurance can be used to create or enhance an estate

Immediate Financial Support:

Life insurance provides immediate financial support to loved ones upon the death of the insured. This can help replace lost income, cover funeral costs, and pay off any outstanding debts or final expenses. It ensures that your family is not burdened by these costs during an already difficult time.

Estate Tax Funding:

Life insurance proceeds can be used to fund estate taxes, which are due within nine months of the policyholder's death. By using life insurance, beneficiaries can preserve the estate's assets, such as an IRA or personal residence, that may otherwise need to be liquidated to cover these taxes.

Preserving Family Assets:

Life insurance can help keep a family business intact and facilitate a smooth transition of ownership. It allows heirs to "cash out" and ensures that the business remains viable, avoiding the need to sell illiquid assets to cover taxes or other expenses.

Estate Equalization:

Life insurance proceeds can be used to equalize distributions among multiple heirs, especially when there are assets that are difficult to divide, such as real estate or a business. This ensures that all beneficiaries receive a fair share of the estate.

Creation of an Immediate Estate:

Life insurance creates an immediate estate for your beneficiaries, often for a relatively small cost. It allows for a direct transfer of funds, bypassing the probate process and its associated costs and delays.

Survivorship Life Insurance:

Survivorship life insurance is taken out on two lives, typically a married couple, and is paid out only after both parties have died. This can be used to offer financial support to children with special needs or to leave a legacy by donating to charities.

Business Buy-Sell Agreements:

Life insurance, combined with a buy-sell agreement, ensures that business partners can afford to buy out the deceased owner's share of the business. This helps maintain the stability and continuity of the business.

Long-Term Healthcare Costs:

New life insurance choices allow policyholders to draw on the death benefit to cover long-term healthcare costs. This can be beneficial for those who may not qualify for long-term care insurance but can obtain life insurance coverage.

Irrevocable Life Insurance Trust (ILIT):

An ILIT can provide flexibility and help manage taxes for your heirs. The trust owns the life insurance policy and receives the death benefit, ensuring that the proceeds are not considered part of the estate for tax purposes. This strategy can be complex and costly, so it's important to consult with a qualified professional before implementing it.

Frequently asked questions