Is Life Insurance Part of an Estate After Death?

You probably know that life insurance can provide valuable assets for beneficiaries, helping them avoid financial hardship and pursue essential goals. But you might not know what happens to life insurance proceeds after you've passed away. For instance, is life insurance part of an estate after death? How is the death benefit payout handled by an estate's executor? Most importantly, what does the death benefit payout mean for your family?

The good news is that life insurance is often a tax-friendly way to help provide financial support and security for others. But the terminology around life insurance and estate planning can get complicated — and it's not always easy to confront some of these serious topics. By exploring some of the most common questions and misconceptions, you can learn more about what to expect. Here's a closer look at how life insurance, trusts and estates work together.

When Is Life Insurance Part of an Estate?

Life insurance often goes directly to beneficiaries without becoming part of your estate. With life insurance, you can name one or more beneficiaries who receive a death benefit shortly after your death. Those payouts typically happen quite fast (within a month or so in many cases), and the death benefit usually doesn't incur taxes for beneficiaries. While there may be exceptions and complications, naming a beneficiary can make difficult times a bit easier for your loved ones.

In some situations, the death benefit goes to the decedent's estate. This might happen if there are no beneficiaries named on a policy or if you own a policy covering your own life and you name your estate as the beneficiary.

Sometimes a policy starts with beneficiaries, but the beneficiaries die before the insured person — so there are no living beneficiaries to receive the death benefit. To help protect against this, you might be able to specify that a beneficiary's descendants should get the death benefit or name backup beneficiaries. However, that might not always be possible or desirable. Ultimately, it depends on your goals and the details of your situation. An estate planning attorney can help you anticipate the opportunities and pitfalls and discuss strategies that might improve things.

What Happens When Life Insurance Goes to the Estate?

If there are no living beneficiaries named on your life insurance policy, the death benefit could potentially go to your estate. In that case, the proceeds would be counted among the assets and liabilities that remain after your death.

Assets in your estate get distributed according to the instructions in your will. Or, if you don't have a will, state laws often dictate who receives any remaining assets. Either way, the death benefit is a resource that can be used to pay off creditors or provide a legacy for loved ones.

In some cases, a death benefit from a life insurance policy may be protected from creditors — even if the money goes to your estate. Laws vary from state to state, so it's critical to review your situation with an attorney who is familiar with local laws.

If you'd rather not take your chances, you can prevent the death benefit from going to your estate by keeping your beneficiary designations up to date.

Be Mindful of Estate Tax

It's crucial to be tax-savvy when using life insurance. A substantial death benefit can potentially increase your estate's value to a level that triggers federal or state taxation. If that happens, your beneficiaries might end up with less money after taxes.

The federal estate tax applies to large estates — those worth at least $13.61 million as of 2023.¹ Assets above that level may result in fairly steep taxes. Paying taxes at high rates on a life insurance payout might be unfortunate.

Some states also impose estate taxes. While most states don't, those that do have relatively low thresholds compared with the federal estate tax. For instance, Oregon taxes estates that are worth $1 million or more.²

Give Thought to Inheritance Taxes

Your beneficiaries might also face inheritance taxes if life insurance goes through your estate. However, they would not owe inheritance tax if the policy pays them directly (as designated beneficiaries of a policy). Like estate taxes, most states do not have inheritance taxes.

Note that certain beneficiaries do not have to pay these taxes. Spouses are often exempt from estate and inheritance taxes when receiving assets. Other close family members might also qualify for exemptions. Still, working with a tax expert to explore potential tax liabilities and strategies for managing taxes is critical.

Does Life Insurance Go Through Probate?

Probate is the process of settling your estate — or managing your affairs after death. Your estate consists of assets and liabilities that remain in your name after death, including money in bank accounts, investments, real estate, personal belongings and more. During the probate process, an executor typically works with local courts to prove the validity of your will and gain authority to handle your assets and liabilities. So, the question becomes: Is life insurance part of an estate after death?

Assets that are part of your estate typically go through probate. There may be exceptions or opportunities for streamlining probate on small estates, but in most cases, assets must be probated. That includes the payout from a life insurance policy if it goes to your estate.

However, if the death benefit goes directly to designated beneficiaries, the money does not go to your estate. As a result, the life insurance payout would not be subject to probate. Instead, the life insurance contract dictates where the money goes before the money ever reaches your estate.

There may be advantages and disadvantages of having a life insurance payout go to your estate. For example, probate can be expensive and time-consuming depending on the situation. In many cases, probate takes a minimum of six months, and it can easily take longer. But a life insurance beneficiary can often claim a payout much faster. Likewise, probate costs might depend on the size of your estate. Adding a sizable death benefit to other estate assets may lead to additional expenses.

All that said, there might be good reasons for having a death benefit go through probate.

   Avoid probate with direct beneficiary designations in life insurance. Get a Life Insurance Quote  

Does a Will Determine How a Life Insurance Death Benefit Is Distributed?

A last will and testament only determines how to distribute a death benefit when the death benefit goes to the estate. If that happens, the money is added to other estate assets. From there, the executor of estate after death distributes excess assets to any beneficiaries according to the will's instructions.

However, your will does not affect a life insurance policy with living beneficiaries. That's because the death benefit goes directly to beneficiaries designated in the life insurance contract, regardless of what the will says. As a result, it's important to understand that beneficiary designations can prevent a death benefit from ever reaching your estate.

In other words, any beneficiary designations can potentially override or take precedence over instructions in your will, so it's critical to review your will and beneficiary designations regularly.

Can You Put Life Insurance in a Trust?

Your will isn't the only way to distribute assets after death. It might not make sense for beneficiaries to get a large death benefit immediately after you die. If you'd rather have more control over how and when your loved ones receive proceeds from your estate or a life insurance policy, it's worth considering trusts as part of your estate plan.

What's more, using a trust can potentially keep life insurance proceeds out of your estate. Again, that may make it easier for beneficiaries to get payouts quickly and reduce probate costs.

There are at least two ways to use trusts in tandem with life insurance: You can name a trust as the beneficiary of a life insurance contract, and you can use irrevocable life insurance trusts to avoid having insurance proceeds become part of your estate. Other techniques or combinations of strategies could also make sense. Speak with an estate planning attorney to explore your options and execute legal documents that are customized for your goals.

Naming a Trust as Beneficiary

When you name a trust as the beneficiary of a life insurance policy, the death benefit gets paid to the trust. From there, the trust document determines if and when any money is distributed to the trust's beneficiaries. This approach allows for a high degree of control over payouts from the trust because the trustee must follow your instructions — even after your death.

Controlling disbursements may be appealing if you're concerned about giving beneficiaries a substantial lump-sum payment when a life insurance policy pays out. For example, if you have minor children, you might prefer to choose a responsible adult to manage the trust on their behalf. Or, if the proceeds are going to adults with spending problems (or aggressive creditors), limiting the beneficiary's access to money might be helpful.

You can also help protect beneficiaries from themselves by establishing rules for when they can get money out of the trust. For instance, you might say that the trust holdings can go toward housing costs or higher education expenses, but that other spending is restricted.

Irrevocable Life Insurance Trusts

If you're concerned about estate taxes, it could make sense to use an irrevocable life insurance trust (ILIT) to manage the level of assets in your estate. With such an approach, the trust owns the life insurance policy and receives the death benefit. As a result, the death benefit — and any cash value in the policy — are not part of your estate. Again, a trust document details how and when money is paid out.

   Plan your estate with life insurance and trusts. Get a Life Insurance Quote  

Is Life Insurance Considered an Asset?

Life insurance is often considered an asset. The payout from a death benefit is certainly a resource that your loved ones can use for purchases, investments and collateral. But life insurance can also be an asset before death.

If a policy has a cash value, it may be possible to use that money through loans or withdrawals during your lifetime. Note that you should always determine whether a withdrawal or a loan is preferable for their individual situation because cash value accumulates over time. However, you must carefully monitor the policy when you tap the cash value. If you deplete the cash value, you risk losing coverage, which may result in financial hardship for your loved ones and potential tax consequences. Plus, unpaid loans reduce the amount your beneficiaries and may cause the policy to lapse. That said, cash value can be a useful source of money, especially during times of need.

How Does Life Insurance Create an Immediate Estate?

The death benefit from a life insurance policy can provide a significant cash injection that makes an immediate impact difference your beneficiaries. You might qualify for a sizable death benefit by paying modest premiums, thereby creating a substantial legacy for others. Although claiming a death benefit often takes one or two months, life insurance proceeds are available to beneficiaries relatively quickly.

Bottom Line

Life insurance can provide a large payout that helps protect families and helps transfer wealth to the next generation. But the nature of those large payouts can be complicated. Because of that, it's crucial to anticipate the tax consequences and logistics for family members.

In some cases, it makes sense to name beneficiaries and pass assets directly to loved ones without the money or property having to go through your estate and the probate process. In other cases, you might prefer to use trusts or name your estate as a beneficiary.

To determine what's right for you and your loved ones, it's a good idea to speak with a team of professionals. An estate planning attorney is essential, and other financial professionals can play pivotal roles. For instance, a CPA can help you manage taxes and report transactions to the IRS correctly, and a qualified insurance agent or financial planner can help you implement any strategies you decide to pursue.

   Secure your estate with life insurance. Get a Life Insurance Quote  

Sources

1. Estate tax. https://www.irs.gov/businesses/small-businesses-self-employed/estate-tax.
2. Estate Transfer and Fiduciary Income Taxes. https://www.oregon.gov/dor/programs/businesses/pages/estate.aspx.