Life Insurance Beneficiary: Who Executes The Estate?

Life insurance is a crucial aspect of estate planning, providing financial security for beneficiaries and helping them avoid economic hardship. While the death benefit from a life insurance policy can be a significant sum, the process of distributing it can be complex. The answer to the question Who is the sole beneficiary of life insurance? is not always straightforward, as it depends on various factors, including the type of life insurance, the presence of a will, and the laws of the state. Understanding how life insurance, wills, and estates interact is essential for ensuring your wishes are fulfilled.

The role of an executor

Executors are responsible for notifying financial institutions and government agencies of the testator's death, acting on behalf of the estate in court, managing ongoing finances, and maintaining and/or disposing of property. They must also divide the assets according to the will, ensuring that all taxes and outstanding debts are paid.

Executors cannot mishandle the will, mismanage assets, or combine assets with their own. They are obligated to act in the best interest of the estate and cannot sell assets under market value.

In the context of life insurance, it is important to note that an executor is responsible for probate assets, while life insurance is considered a non-probate asset. This means that the executor does not directly handle life insurance proceeds, which are typically distributed directly to the named beneficiaries outside of the probate process. However, the executor may notify the insurance company of the testator's death to initiate the distribution process.

Probate and life insurance

Probate is the legal process of dividing and transferring ownership of inherited assets in the case of someone's death. A court official reviews the estate, follows the deceased's will (if applicable), and settles any outstanding debt while distributing assets to beneficiaries. Probate laws vary by state, but the process is generally simplest when there's a comprehensive will or an irrevocable trust, and no dispute among potential heirs.

Life insurance proceeds usually bypass the estate and go directly to named beneficiaries. Provided the life insurance policy is active and the insured meets the terms of coverage, a beneficiary will be paid the value of the policy's death benefit.

However, if there's no specified person (or organisation) as the beneficiary on the life insurance policy when the owner dies, the asset goes to probate. Here are some common scenarios that will trigger life insurance benefits to go through probate:

• The estate is named as the beneficiary.
• There is no named beneficiary.
• The named beneficiary has died.
• The policy owner gets divorced and their ex-spouse remains the beneficiary.

To avoid probate, it's essential to name a living beneficiary on your life insurance policy and update the paperwork if circumstances change. Adding a backup beneficiary can also be helpful. Alternatively, you can direct the life insurance proceeds to a trust set up to benefit your loved ones or another organisation.

Benefits of avoiding probate for life insurance include timeliness, saving money, protecting privacy, and keeping the proceeds free of debt.

It's also important to note that beneficiary designations on a life insurance policy override will instructions. If there is no will, the money is distributed according to state laws. Proceeds may incur taxes if the estate exceeds certain tax thresholds.

How to avoid probate

Probate is the legal process of dividing and transferring ownership of inherited assets in the case of someone's death. In probate, a court official reviews the estate, seeks to follow the deceased’s will (if applicable), and settles any outstanding debt while distributing assets to beneficiaries.

Name a Living Beneficiary

The simplest way to avoid probate is to name a living beneficiary on your life insurance policy and keep the paperwork updated. Adding more than one beneficiary or a backup beneficiary can be helpful. If you're undecided, direct the life insurance proceeds to a trust set up to benefit your loved ones or another organisation.

Set Up a Trust

Using a trust as a life insurance beneficiary gives you control over the payout timing and keeps the proceeds out of the estate. You can name a trust as the beneficiary of a life insurance contract, and the death benefit gets paid to the trust. From there, the trust document determines if and when any money is distributed to the trust's beneficiaries.

Create an Irrevocable Life Insurance Trust (ILIT)

An ILIT names the trust as the beneficiary of the insurance policy. This separates the insurance policy payout from the estate, so the taxable value of the estate does not increase. The bylaws of the trust could state that the money in the ILIT is to be used to settle your estate's debts or to make whatever payments you choose. This protects heirs from being forced to sell real estate, stocks, or other assets to raise cash.

Life insurance and estate tax

Life insurance is often a tax-friendly way to provide financial support to your beneficiaries. However, there are certain scenarios where the proceeds from a life insurance policy can be taxed.

In general, the payout from a term, whole, or universal life insurance policy is not considered part of the beneficiary's gross income and is therefore not subject to income or estate taxes. There are, however, some exceptions to this.

• Payout structure: If the payout is set up to be made in multiple payments, these payments can be taxable. For example, an annuity paid regularly over the life of the beneficiary may be subject to taxes.
• Policyholder withdrawals or loans: If the policyholder has withdrawn money or taken out a loan against the policy that exceeds the total amount of the premiums paid, the excess may be taxable.
• Surrendering your policy: If you surrender your policy, any funds over your policy's cash basis will be taxed as regular income.
• Employer-paid group life plan: In some cases, an employer-paid plan that pays out more than $50,000 may be taxable according to the Internal Revenue Service (IRS).
• Estate value: If the life insurance proceeds are included as part of the deceased's estate and together exceed the federal estate tax threshold ($12.92 million as of 2023), estate taxes must be paid on the proceeds over the allowed limit.

To prevent estate tax on life insurance proceeds, the insured must avoid two things:

• Payment to the insured's estate: Ensure that the estate is not designated as the beneficiary of the policy.
• Incidents of ownership: The insured should not retain any "incidents of ownership" in the policy. This includes outright ownership as well as certain rights such as the right to change the beneficiary, borrow against the policy, pledge the policy as security for a loan, or surrender or cancel the policy.

Other strategies to avoid estate tax on life insurance proceeds include:

• Buy-sell agreements: Life insurance obtained to fund a buy-sell agreement for a business interest under a "cross-purchase" arrangement will not be taxed in your estate unless the estate is named as the beneficiary.
• Life insurance trusts: An irrevocable life insurance trust (ILIT) can be set up to keep life insurance proceeds from being taxed in the insured's estate. The trust agreement must give the insured none of the ownership rights mentioned above.
• The three-year rule: If you are considering setting up a life insurance trust, it is important to act early. Unless you live for at least three years after these steps are taken, the proceeds will be taxed in your estate.

Life Insurance and Probate

Life insurance proceeds typically bypass the estate and go directly to the named beneficiaries. However, if there are no beneficiaries or the beneficiaries have died, the proceeds may become part of the estate assets and will be distributed according to the will or state laws.

To keep life insurance proceeds out of your estate, it is important to name a living beneficiary on your life insurance policy and update the paperwork if circumstances change. Adding a backup beneficiary can also be helpful. Alternatively, you can direct the life insurance proceeds to a trust set up to benefit your loved ones or another organization.

Life insurance as an asset

Life insurance is often considered an asset, though this depends on the type of policy and whether you can benefit from it while alive. Term life insurance, which only pays out to dependents in the event of your death, is not an asset. However, whole life insurance and other permanent life insurance policies with a cash value component are considered assets as they can be withdrawn from while the policyholder is alive.

The death benefit of a life insurance policy is not usually considered an asset, but it can be used to provide financial stability for your family and beneficiaries after you are gone. This is a lump-sum payment, called a death benefit, which is paid to the beneficiaries of the policy.

Some types of permanent life insurance have an additional living benefit called cash value, which is considered an asset. This is because the policyholder can access this cash value while they are alive. Whole life insurance and universal life insurance are the most common policies that can build cash value. A small amount of each premium payment goes into the cash value, which can be accessed tax-free if the policy is designed properly.

The cash value of a life insurance policy can be used to protect wealth and transfer it to heirs, in addition to the death benefit. It can also help with estate planning, allowing assets to be split evenly among heirs or debts to be paid off, so that tangible assets do not need to be sold.

Frequently asked questions