Estate planning is one of the most difficult and important financial planning processes you’ll ever go through. It’s complex, and the bigger your estate, the tougher it gets. While creating your estate plan, you may find yourself wondering whether your life insurance policy will be part of it. Life insurance can be one way to pay off outstanding debts and financial burdens following your passing. However, many people want the proceeds to go to a loved one instead. In the end, your beneficiary designation determines where the funds go and how it will interact with your estate. Consider working with a financial advisor as you put together your estate plan.
Understanding Life Insurance and Estate Planning
When an individual purchases a life insurance policy, they essentially sign a contract with an insurance company. The policyholder who owns it can then use it to insure someone else or themselves. During the course of their life, the policy owner pays regular premiums to the company. Then, per the contract, once the insured person passes, the company pays out a lump sum of cash called the death benefit to the policy’s beneficiaries.
Policy owners may instead name their estate as the beneficiary of the life insurance. If so, the proceeds will likely pay for debts, like leftover bills or loans. This may also happen by default if the policyholder doesn’t name a beneficiary.
Regardless of whether it passes to a named beneficiary or to your estate, the insurance proceeds can face federal estate taxes. Rates vary from 18% to 40%, depending on your gross estate.
Usually, if the beneficiary on the policy is the estate, then the insurance company must directly pay the probate court. The court first uses said money to pay associated legal costs, like court fees. Afterwards, it distributes whatever amount is left according to the deceased’s will.
But if you purchase a life insurance policy and name at least one beneficiary who is alive at the time of your death, then they will receive the policy’s proceeds. This is a direct transfer, meaning the exchange avoids probate altogether.
The probate process is something you absolutely want to have your family avoid. It’s typically a lengthy and costly series of legal procedures that sort through the deceased’s estate, debt and lines of credit. The court uses funds from the estate to pay any remaining debt following the passing. But by naming a beneficiary, the funds solely belong to the named recipient, meaning the court and creditors cannot touch them.
Estate Planning for a Life Insurance Policy Without a Beneficiary
Occasionally, issues may arise regarding the beneficiary. For example, let’s say the life insurance policyholder fails to designate one in the first place. Or, they suddenly change the beneficiary at the last minute. In the latter situation, both the original beneficiary and insurance provider will probably contest the change.
But things can become even more difficult if there’s no designated beneficiary at the time of the decedent’s passing who is alive. So if the decedent’s choice of beneficiary has also passed away at the time of their death, there can be a few different resolutions.
In some cases, the proceeds from the life insurance policy go to the probate estate. There, the estate uses the funds to cover any remaining bills and costs. Other times, the life insurance proceeds pass on to the living heirs-at-law of the policyholder. Heirs-at-law are close relations with a legal entitlement to the deceased’s assets if they died without a will. Going to the heirs-at-law protects the funds from creditors and leftover debt on the estate.
Ultimately, though, the insurance company’s payment policy and the local laws based on the estate’s location influence where the insurance money goes.
Naming a Trust as Your Life Insurance Beneficiary
Ensuring your beneficiaries are well taken care of is a challenge. You want to guarantee they receive what they need and help them make the most of their future benefit. That requires you to minimize the eventual taxes on anything you pass down.
One solution people use to lessen the tax burden on your life insurance payout is to name a trust as the primary beneficiary. In particular, they use an irrevocable trust. Irrevocable trusts are trusts you, the grantor, cannot change. Only beneficiaries can approve or make changes once you create the trust. Naming an irrevocable trust as the beneficiary allows you to put your money away without paying taxes on it. After, the designated beneficiary of the trust can take out the funds.
While this means your beneficiary does not directly receive the money, it preserves the amount. This way, the funds don’t experience the bite of estate taxes. But this is at a cost. You cannot touch, amend or borrow from the policy once you transfer it to the trust.
Alternatively, you can use a revocable, or changeable, trust. These provide a little more flexibility, which may be helpful if your circumstances change. And they help loved ones skip the process. However, you still technically own assets in a revocable trust, making them part of your estate. So, a revocable trust does not allow you or your beneficiaries to avoid estate taxes. This may not be an issue for smaller estates that don’t qualify for the estate tax, though.
You might not even need a trust ultimately. If you name your spouse as the policy beneficiary, there’s usually no issue, thanks to the unlimited marital deduction. Assets exchange between spouses on an estate-tax-free basis as long as the spouse is a U.S. citizen.
Bottom Line: Is Life Insurance Part of an Estate?
Life insurance policyholders need to remember one vital thing when naming a beneficiary: be specific. You should not leave anything up to guesswork. If you worry that your intended beneficiary may pass, name several. But name each one specifically.
Otherwise, they may have to wait a lengthy amount of time to receive the policy’s death benefit. Or, they might even need to go to probate court to contest if things are too ambiguous. Probate is both long, taking upwards of a year, and costly. You can help your loved ones avoid that by acting carefully.
Estate Planning Tips
Consider working with a financial advisor as you create or modify an estate plan. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
Our insurance calculator determines exactly how much life insurance you need and recommends policies that match your needs.
Most estate plans include a will. But there is much more to the process than that, including more documents. Read SmartAsset’s guide to estate planning vs. wills to help you prepare.
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