What Happens if My Life Insurance Becomes Part of My Estate?
When most people have life insurance, beneficiaries are named so that they receive the proceeds when the policyholder dies. However, there are situations where life insurance proceeds will be allocated to the policyholder's estate instead. An estate is generally all the property that is solely owned by a person after he or she dies. The most common scenarios are neglecting to name a beneficiary, or the beneficiary predeceases the policyholder and a new one does not get named.
Designating a beneficiary of a life policy does not necessarily require a will. You may designate a beneficiary, or beneficiaries, to a life policy directly; or you may designate a beneficiary, or beneficiaries, to a life policy through provisions in a will or trust.
Dying without a will is dying intestate. If a policyholder dies intestate and hadn't designated a beneficiary to the life policy, the proceeds of the life policy may have to processed in probate. If you are unsure who to name as a beneficiary or you haven't made a will yet, here are some things you should be aware of if your life insurance proceeds become part of your estate.
The term "Probate" refers to the process in which an individual's estate is handled after death. The purpose of probate is to help ensure that the property or assets of the person who has perished are going to the proper beneficiaries. Probate helps ensure that any creditors are also paid their outstanding debts. Often, probate can be a lengthy process and may also be quite costly. As such, it may prevent the beneficiaries from receiving a death benefit in a timely fashion.
Life Insurance and the Estate Tax
Most people do not have to worry about the federal estate tax. Prior to the 2018 tax reform, only about 0.1% of Americans paid the estate tax. 1 In 2017, the federal estate tax kicked in when a taxable estates was worth $5.49 million or more. This threshold more than doubled to $11.18 million in 2018 and is currently at $11.4 million.2
Subsequently, in recent years, avoiding the estate tax has not been as much of a focal point as it used to be. It may remain a risk at the state level however, particularly if a state has a low threshold and the value of the decedent's home or retirement assets alone could trigger state-level estate tax. The cash surrender value of a whole life insurance policy often takes 12-15 years of payments to have that value exceed your premium payments (15-20 years for universal life insurance). If you've had steady employment and access to group term insurance for more than a decade, this cash value can be easily overlooked and can wind up making your estate a taxable one.
In the event that you anticipate your taxable estate exceeding the estate tax exclusion, it is advisable to name a beneficiary for that life insurance death benefit rather than including those death benefits into your estate for both federal and state purposes.2
Read more about the tax benefits of a life insurance policy.
If Proceeds Produce Taxable Income at the Estate Level
A simple estate where the decedent had no living relatives will close relatively quickly, even if it gets sent to probate. But there are many cases where the estate remains open, such as if beneficiaries are having disputes regarding distribution of assets or if the decedent owned a business or perpetual forms of income like film and book royalties.
This makes the estate a taxpaying entity like a business, individual, or trust and it must file a tax return on this income. The estate tax pertains to the value of your assets at the time of death, but an estate tax return is a fiduciary return pertaining to how much income your assets have generated after your death.
To illustrate this concept, let's say that you die intestate and your life insurance pays out $500,000 at your death. Due to the probate process taking time, it accrues $25,000 in interest. The $500,000 gets allocated to your estate with no estate tax, but the $25,000 becomes taxable income to the estate. The tax is effectively 30.5% of that income ($7,637) which can be easily twice what an individual would pay on this income.
If you don't have much family to leave anything to, this could seem inconsequential. But if you have friends, community members, and causes you care about, it helps to name one or more of them as a beneficiary, even if you don't have a will set up yet. Ultimately, by having your life insurance become part of your estate, you ensure that it will go to any living relatives if you have no assigned beneficiary at the policy level or through a will. Plus, it may leave them with less due to estate income taxes.
2. Although the estate tax exclusion is currently above $11 million, that is not assurance that Congress will not reduce that amount in future years. All planning associated with your estate and any tax consequences should be addressed with a tax or legal advisor.