Deciding how to structure life insurance can be one of the most important choices you make in your estate plan. Along with providing for your loved ones, a well-planned life insurance policy can help you avoid probate, reduce taxes, and protect key assets.
And, because life insurance has a significant impact on how your estate is ultimately administered, it’s vital to have a clear understanding of how a policy interacts with other estate-planning tools.
Whether you’re using a will, a trust, or some combination, the goal should be to structure your policy to best complement the rest of your estate plan – and to maximize the legacy you leave behind.
3 Parties to Life Insurance Policy
Life insurance policies have three indispensable parties (not including the insurance company).
First, there is the “insured” – the person whose life the insurance company is insuring. The insured usually is the owner of the policy, but not always. It is possible to be the owner of the policy taken out life insurance on the life of another.
Then, there’s the “policyholder” or owner. The owner is the individual or entity who is responsible for paying premiums and who has the right to access a permanent policy’s cash value. The policyholder also has the right to designate the third key party: the “beneficiary.”
The “beneficiary” is the payee who receives the check from the insurance company after the insured’s death. The life insurance beneficiary is typically a person, although an entity may be the beneficiary.
The key point, though, is that someone stands in each position. And the identities of each make a big difference in how a life insurance policy fits within an estate plan.
For present purposes, we’re assuming the insured is the person developing the estate plan and is either the policyholder or has some say in deciding who the policyholder will be.
In this scenario, the policy needs to be considered in the estate plan, with special attention paid to the beneficiary designation.
There are three basic options for designating a beneficiary.
You can name a third-party to receive proceeds directly; name your estate so that the pay-out is administered in probate; or name a trust and fund it with policy proceeds.
Each approach comes with pros and cons. When making the choice, you’ll want to carefully consider your individual objectives and adopt the approach that best complements the rest of your estate plan.
Designating a Third-Party Beneficiary.
A “third-party beneficiary” is a payee other than the insured. When a policy has a third-party beneficiary, it automatically pays out to the beneficiary upon the insured’s death.
Now, the insurance company might not cut the check immediately – there will be some paperwork. But the right to receive the money vests as soon as the insured dies.
This is an important point because it means the policy proceeds are not included within the probate estate.
Avoiding probate saves time, money, and hassle. And, if the estate has creditors, they won’t be able to attach the policy proceeds during the estate-administration process.
Probate estate vs Taxable estate
It’s worth noting that a “probate estate” and a “taxable estate” for purposes of federal estate taxes are not always the same.
Policy proceeds paid to a third-party beneficiary skip probate but may still end up in your taxable estate if you have any “incidents of ownership” in the policy.
So, if you’re the policyholder, the payout may trigger estate taxes (subject to the exemption discussed below).
But, if someone else, like a family member or a trust, owns the policy and you don’t have any right to make changes or receive cash value, there’s a good chance it won’t trigger the same estate taxes.
The downside of naming a third-party beneficiary is that you give up any right to control how policy proceeds are used.
You do decide who gets the money, but once the beneficiary receives the distribution, it belongs to him or her.
Along the same lines, proceeds paid to a named beneficiary are generally not available to pay estate expenses.
So, if you’ve earmarked life insurance money to pay taxes, administration costs, and creditors, a third-party beneficiary isn’t the way to go unless you’re confident the beneficiary will use the money as you intended.
Even if you designate a third-party beneficiary to avoid probate, it may still be worth mentioning a life insurance policy in your will. On the off chance that the named beneficiary dies first or elects to disclaim the payment, you might need a back-up plan.
Life Insurance Proceeds in Probate.
Rather than paying directly to a beneficiary, a life insurance policy can be structured so that proceeds become part of your probate estate and can therefore be addressed in your will.
If a policy’s named beneficiary is the insured or the insured’s estate – or if there is no beneficiary – proceeds are paid to the estate and administered by the executor alongside other assets.
Life insurance proceeds, like other assets, are distributed by the executor according to instructions set forth in the decedent’s last will and testament.
However, before an executor makes distributions, creditors have the opportunity to assert claims against estate assets.
Although life insurance proceeds are usually exempt from creditor claims in most states, the exemption generally applies if the beneficiary is someone other than the insured or the insured’s estate.
Thus, a life insurance payout that goes through probate is potentially exposed to creditor attachment.
So, why would you want life insurance proceeds in your probate estate if the money is exposed to creditors?
One possible answer is that you might want the insurance money to be available for creditors.
If, for example, your estate includes valuable illiquid assets like real estate or ownership interests in a business, cash from life insurance protects those other assets by ensuring sufficient liquidity to pay administration costs, creditors, and taxes.
If the alternative is for the executor to sell off a family farm or closely held business, exposing life insurance money to creditor claims might be a smart move.
The probate process also allows a little more flexibility in deciding how life insurance proceeds are distributed.
In your will, you can divide insurance money in your estate between whichever heirs you choose in whatever portions you deem appropriate.
A Will Does Not Invalidate Beneficiary Designations
Notably, though, you cannot alter a life insurance policy’s beneficiary via a provision in your will.
To change a beneficiary, you must amend the designation on the policy itself by submitting the appropriate forms to the insurance company. This is because a will only apply to assets within the probate estate, and a policy with a third-party beneficiary doesn’t pay into the estate.
So, if you want life insurance proceeds to pass through probate, the named beneficiary should be your estate.
Whether paid by the insurance company directly to a named beneficiary or by an executor after probate, once received, life insurance proceeds come under the exclusive control of the recipient.
In your will, you can express your wishes as to how the money should be used, but such statements are non-binding for the most part. If you want to exercise any control over the ultimate use of the funds, your best bet is to set up a trust.
Naming a Trust as Beneficiary of a Life Insurance Policy.
Both testamentary and living trusts can serve as the beneficiary of a life insurance policy. Life insurance payable to a trust skips probate and is paid directly into the trust upon the death of the insured.
Once in the trust, the funds are managed by a trustee, who invests and/or distributes the trust’s assets to designated beneficiaries according to directions provided by the grantor.
Along with bypassing probate, the chief advantages of paying life insurance into a trust are flexibility and extended control over the ultimate use of the money.
You get to tailor the distribution approach to your specific objectives, allowing the trustee wide discretion or very little at all.
You might, for instance, direct the trustee to pay any estate debts, taxes, and costs of administration and then gradually disburse the remainder to the trust’s beneficiaries over a period of years.
Or, depending upon the amount involved, you could direct the trustee to invest the money prudently and pay out the growth plus a maximum percentage of principal each year.
The important part is that, within the bounds of the law, you have the flexibility to apply the insurance proceeds in the way you think best, while protecting beneficiaries from creditor claims or their own wasteful spending.
An Irrevocable Life Insurance Trust (“ILIT”) is a specialized form of trust designed to mitigate estate tax liability by keeping life insurance out of your taxable estate. The trust itself is both policyholder and beneficiary. And, by definition, it’s irrevocable, so once the trust is set up, you can’t make any changes to it.
During life, you have to fund an ILIT with sufficient cash to cover premiums. If premiums are less than $15,000 per year, they are within the annual gift tax exclusion. You can apply any excess to the combined estate / gift tax lifetime exemption, or just pay the gift taxes.
At death, the insurance company pays the life insurance proceeds directly to the trust, and the trustee manages and distributes the funds according to the trust’s instructions.
Significantly, because the trust is irrevocable, the proceeds are completely excluded from the federal estate tax. This makes an ILIT a useful set-up if policy proceeds would push an estate over the exemption ($11.4 million as of 2019).
For high net worth planning with life insurance, an irrevocable trust makes a lot of sense. For those estates below the current exemption, an ILIT may not be necessary. Just be aware that the exemption limit has been very low and may be again.
Another benefit of an ILIT is that it can prevent insurance proceeds from increasing the tax burden on an estate that already qualifies for the tax.
ILITs are of particular use for estates with substantial valuable assets but relatively low liquidity (e.g., a family-owned business or farm).
Sufficient life insurance held in an ILIT guaranties that debts, administration costs, and estate and property taxes can be paid without selling off other assets and without incurring additional tax liability for the pay-out.
As an alternative to naming a trust as beneficiary, you can have insurance proceeds paid into your estate and then distributed to a testamentary trust (i.e., a trust created by a will that does not come into existence until death).
With this approach, the insurance money passes through probate and is then paid into the testamentary trust by the executor. This adds an extra layer that is sometimes unnecessary but can be useful for specific purposes, such as if you have an heir who you would like to receive some of the policy proceeds but who you do not want to designate as a beneficiary of the trust.
Life insurance and estate planning go hand in hand. A properly designed policy and estate plan can protect your heirs from needless hassles and expenses upon your death.
If you have further questions, please give us a call or leave a comment below.