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. The most common scenarios are neglecting to name a beneficiary, or the beneficiary predeceases the policyholder and a new one does not get named.
You don't need to have a will in order to name a beneficiary, and beneficiaries do not have to be your spouse, child, or even related to you. In some states, there are laws that allow very close relatives like children or siblings to claim your life insurance if you died intestate, did not name them in the will, or they were not named beneficiaries on the policy. However, it is prudent to at least have a will that names beneficiaries if you have not decided on a beneficiary specifically for your life insurance.
If a policyholder dies intestate (without a will) and has no beneficiaries named for the life insurance policy, the death benefits are very likely to go to probate. If you are unsure who to name as a beneficiary or you haven't made a will yet, here is what you should be aware of if your life insurance proceeds become part of your estate.
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.
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 $11 million, you will definitely want to name a beneficiary instead of risking the proceeds becoming part of your estate to avoid this tax on both federal and state levels.
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.
For instance, it's common for beneficiaries to receive tax-free life insurance proceeds but receive a tax form for interest paid on those proceeds. If the cash value of the policy was high, this interest can be a significant amount that can push the beneficiary into a higher tax bracket. However, in spite of the resulting taxes from this payment, the beneficiary will have a more favorable tax rate than the estate. An estate must file its own tax return if it generates at least $600 in taxable income, and the highest tax bracket is 37% with a threshold of only $12,500 if the decedent died in 2018.
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.
Who Benefits?
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.
1. https://www.cbpp.org/research/federal-tax/policy-basics-the-federal-estate-tax