Life Insurance in your Estate

What You Need to Know About Life Insurance and Your Estate

Many people choose to invest in a life insurance policy. Some choose to purchase a term life insurance policy wherein the insured pays a premium for a period of years and if he or she passes away during that period of time, the policy will pay out to the designated beneficiaries, while others purchase whole life insurance which works more like an investment product and has a guaranteed payout no matter the insured’s age.

While there are many different kinds of life insurance policies, from an estate planning point of view, all proceeds from a life insurance policy are taxable in the estate of the policyholder. This comes as a surprise to many since typically life insurance does not pass through your estate.

It is important to make a distinction between your “probate estate” and “gross taxable estate”.  Probate is the process in which your Will is admitted to and approved by the Surrogate’s Court.  Probate assets are those assets which pass through your Will, are collected by the Executor and are subject to the claims of your creditors.

Contrast the probate estate with the gross taxable estate. The gross taxable estate includes not only those assets which pass through your Will, but also include all other assets in which you had any incidence of ownership at the time of your death.  This includes but is not limited to life insurance proceeds, Individual Retirement Accounts (“IRAs”), and joint bank accounts.

Life insurance proceeds are transferred to your beneficiaries by a designation of beneficiary form properly filled out and delivered to your insurance company.  Assuming that you have designated someone as the beneficiary of your life insurance proceeds, these assets will not pass through your estate and therefore will not be subject to probate and will not be subject to creditor’s claims as the proceeds pass directly to the beneficiary.

However, the proceeds are taxable in your estate.  If you own an insurance policy, or have certain ownership interests (i.e., the right to change the beneficiaries on the policy), then the entire value of the insurance proceeds will be taxable in your estate when you die, even though these assets are not subject to the probate process.

If your estate is taxable, you can create an irrevocable life insurance trust which owns the life insurance policy.   Creation and proper funding of such a trust can avoid estate taxes on those policies owned by the trust If you already own an insurance policy and you transfer that policy to an irrevocable trust, the value of the policies transferred into the trust will be taxable in your estate if you die within three years of transferring these policies into the trust.  For this reason, it may make sense to create an irrevocable life insurance trust simultaneously with the purchase of a new life insurance policy.  If the trustee of the trust purchases the life insurance, then there will be no estate tax liability at any time because the three year rule does not apply.