Estate planning is one of the most difficult and important financial planning processes you will ever go through. It’s complex, and the larger your estate, the more difficult it becomes. When developing your estate plan, you may wonder if your life insurance policy will be part of it. Life insurance can be a way to pay off unpaid debts and finance charges following your death. However, many people want the proceeds to go to a loved one instead. Ultimately, your beneficiary designation determines where the funds go and how they will interact with your estate. Consider work with a financial advisor as you develop your estate plan.
Understanding life insurance and estate planning
When an individual buys a life insurance policy, they basically sign a contract with an insurance company. The policyholder who owns it can then use it to insure someone else or himself. During his lifetime, the contract holder pays regular premiums to the company. Then, in accordance with the contract, once the insured person dies, the company pays a lump sum in cash called death benefit to the beneficiaries of the contract.
Instead, policyholders can designate their estate as the life insurance beneficiary. If so, the proceeds will likely be used to pay debts, such as bills or remaining loans. This can also happen by default if the policyholder does not name a beneficiary.
Whether passed on to a named beneficiary or your estate, insurance proceeds may be subject to federal estate taxes. Rates vary from 18% to 40%based on your gross assets.
Usually, if the beneficiary of the policy is the estate, the insurance company must pay the probate court directly. The court first uses this money to pay associated legal fees, such as court costs. Then, he distributes the amount that remains according to the will of the deceased.
But if you purchase a life insurance policy and name at least one living beneficiary at the time of your death, they will receive the proceeds of the policy. This is a direct transfer, which means that the exchange completely avoids probate.
The approval process is something you definitely want your family to avoid. It is usually a long and expensive series of court proceedings that sort through the deceased’s estate, debt and lines of credit. The court uses funds from the estate to pay any outstanding debt after death. But by naming a beneficiary, the funds belong only to the named recipient, which means the court and creditors cannot touch them.
Estate planning for a life insurance policy without a beneficiary
Sometimes issues can arise regarding the beneficiary. For example, suppose the life insurance policyholder does not appoint one in the first place. Or, they suddenly switch beneficiaries at the last minute. In the latter case, the original beneficiary and the insurer will likely dispute the change.
But things can get even more difficult if there is no named beneficiary at the time of the deceased’s death who is alive. Thus, if the beneficiary chosen by the deceased is also deceased at the time of his death, there may be several different resolutions.
In some cases, the proceeds of the life insurance policy are paid to the estate of probate. There, the estate uses the funds to cover bills and remaining costs. Other times, the life insurance proceeds pass to the living heirs of the policyholder. Legal heirs are relatives with a legal right to the property of the deceased if they died without a will. Going to legal heirs protects funds from creditors and balance of debts on the domain.
Ultimately, however, the insurance company’s payment policy and local laws based on the location of the estate influence where the insurance money goes.
Designating a trust as the beneficiary of your life insurance
Ensuring your beneficiaries are well taken care of is a challenge. You want to ensure they get what they need and help them get the most out of their future benefits. This forces you to minimize the possible taxes on everything you send.
A solution that people use to reduce 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 that you, the settlor, cannot change. Only beneficiaries can approve or make changes after you create the trust. name a irrevocable trust because the beneficiary allows you to put your money aside without paying taxes on it. Afterwards, the designated beneficiary of the trust can withdraw the funds.
Although this means that your beneficiary does not receive the money directly, it preserves the amount. This way, the funds do not suffer the bite of property taxes. But this has a cost. You cannot touch, modify or borrow against the policy once you have transferred it to the trust.
Alternatively, you can use a revocable or changeable trust. These offer a little more flexibility, which can be useful if your situation changes. And they help loved ones avoid the process. However, you still technically own assets in a revocable trust, making it part of your estate. Thus, a revocable trust does not allow you or your beneficiaries to avoid inheritance tax. However, this may not be a problem for small estates that do not qualify for estate tax.
You may not even need a trust in the end. If you designate your spouse as the beneficiary of the contract, there is generally no problem, thanks to the unlimited spousal deduction. Exchange of assets between spouses free of estate tax as long as the spouse is a US citizen.
Conclusion: Is life insurance part of an estate?
Life insurance policyholders should remember one key thing when naming a beneficiary: Be specific. You should leave nothing to guesswork. If you’re worried your intended beneficiary might pass, name several. But name each one specifically.
Otherwise, they may have to wait a long time to receive the death benefit from the policy. Or, they might even need to go to probate court to contest if things are too ambiguous. Probate is both long, taking more than a year, and expensive. You can help your loved ones avoid this by acting with caution.
Estate planning tips
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Consider work with a financial advisor when you create or modify an estate plan. Finding a qualified financial advisor doesn’t have to be difficult. SmartAsset’s free tool connects you with up to three financial advisors who serve your area, and you can interview your advisors at no cost to decide which one is best for you. If you’re ready to find an advisor who can help you achieve your financial goals, start now.
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Our insurance calculator determines exactly how much life insurance you need and recommends policies that meet your needs.
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Most estate plans include a will. But there’s a lot more to the process than that, including more documents. Read SmartAssets guide to estate planning versus wills to help you prepare.
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