Life insurance is an essential financial planning tool for families. Term life insurance, with policy limits sufficient to pay off a mortgage and fund educational expenses, can often be purchased at a low cost, and provide coverage for several decades.
If you already own life insurance or are thinking about purchasing life insurance, here are three important things to think about at the intersection of life insurance and estate planning:
Always Be Mindful of Your Beneficiary Designation
Do you have a beneficiary designation on your policy? If so, after your death, the policy proceeds will flow directly to the designated beneficiary quickly and easily, outside the probate process. If you do not designate a beneficiary, the life insurance proceeds will go through probate to the beneficiaries designated in your Last Will and Testament, and the distribution of life insurance proceeds to the beneficiaries can take substantially longer. As such, you should have a beneficiary designation, and it should always be up to date.
Even if you do have a beneficiary designated, when is the last time you reviewed and reconsidered who it should be? Do you have both an initial beneficiary designated, in addition to a contingent beneficiary (the person who would receive payment if the initial beneficiary has predeceased you)? If you purchased your policy before your marriage, do you still have your parents listed as the initial beneficiary rather than your spouse? If you purchased your policy before having children, do you have your children named as the contingent beneficiary after your spouse? Have you gone through a divorce, and do you need to remove your now ex-spouse as a beneficiary?
Bear in mind that an insurer is under a surprisingly limited duty to consider any extrinsic factors at the time of death. Usually, they are permitted to abide by the beneficiary designation on file exactly as it appears, even if it reflects a significantly different time in the policy owner’s life. The onus is usually on the policyholder to update their beneficiary designation as life happens.
Do You Presently Have a Trust to Hold a Minor’s Inheritance (either a “testamentary trust” or a “living trust”)?
If you have created a trust to hold a minor’s inheritance, whether that is a living trust or a testamentary trust (a trust housed within your last will and testament), you should designate the trust–not the minor child–as the beneficiary of the life insurance (either initial or contingent).
If the minor is designated personally, the insurer may only distribute policy proceeds to a court-appointed guardian of the property or to a custodian under the Uniform Transfers to Minors Act until the child is emancipated. But, the child would then have unrestricted control over life insurance proceeds at age 18 or age 21.
Many clients have intentionally deferred a minor’s control of their inheritance to a later age through the creation of a trust. If you have created a trust for this purpose, but you do not name the trust as the beneficiary of the life insurance proceeds, the insurance proceeds could be received by a minor child with no restrictions at a far earlier age than you intend.
Will the Life Insurance Create an Estate Tax Liability If I Die?
If the addition of life insurance proceeds at the time of your death will cause the value of your “taxable estate” to exceed the state or federal estate tax exemption, you may wish to consider having your life insurance policy owned by an “irrevocable life insurance trust” (an “ILIT”) rather than owned by you personally.
Consider the client with a $5 million life insurance policy and $13 million in other assets. The federal estate tax exemption presently sits at $15 million. If the life insurance policy is added to the other assets owned by the decedent, the client would die with a taxable estate of $18 million. The $3 million over the federal estate tax exemption would be taxed at a rate of 40% – $1.2 million.
Alternatively, if the client holds the life insurance policy in an ILIT, it would not be subject to estate tax. Only the client’s $13 million in other assets would be exposed to federal estate tax. The client is below the federal estate tax exemption, and there would be no federal estate tax due. The ownership of the life insurance policy in the ILIT just saved the owner’s family $1.2 million in estate tax.
Some things to know about an ILIT:
- You can transfer existing policies to an ILIT, but you must survive a three-year look-back period. If you die within that three-year period, your family will still receive the policy proceeds, but the proceeds will be part of your taxable estate.
- The beneficiaries of the ILIT can indeed be the same individuals whom you would otherwise designate if you owned the policy in your individual name.
- The ILIT, however, cannot be managed by you, as the “trustee”.
- The ILIT is “irrevocable,” meaning it is locked once created, and it is very difficult to adapt to changing life circumstances.
- Each year that life insurance premiums are paid, an annual notice must be tendered to the beneficiaries of the ILIT that a contribution has been made to the ILIT in the form of these premium payments.
- If the premium payments to the ILIT exceed the annual gift tax exemption ($19,000.00 in 2026), a gift tax return may be required.
Estate planning includes not just the creation of documents but also a holistic review of a client’s assets to ensure everything aligns with their objectives. How can we help you with your estate planning? Contact Liz Farley at lfarley@bulmandunie.com or (301) 656-1177 x316 or Jeremy Rachlin at jrachlin@bulmandunie.com or (301) 656-1177 x305 to schedule a review appointment or free consultation.
