For the financially savvy and prudent among us, purchasing life insurance is a given. Although every policy has a price tag, life insurance is generally seen as a “safe” investment — one that won’t result in surprising taxes or unforeseen deductions. And, like completing an estate plan, buying life insurance can create a sense of security — you’ve done what you can to protect those you’ll leave behind one day.
But what actually happens when that fateful day arrives? When your loved ones are in the midst of the probate process, will the life insurance policy you purchased help them or hurt them?
Luckily, with some advanced planning, you can ensure that your actions will help them cover costs during a difficult time.
[Need help with probate? We offer helpful probate services and will work with you to find the plan that meets your needs. Learn more.]
The probate process
Before diving into how life insurance impacts probate, we need to understand the probate process.
In general terms, probate is the process where a court approves a will and appoints an executor to carry out the payment of debts and distribution of assets from an estate. If there’s no will, the court appoints an administrator and directs them on the payment of debts and distribution of assets as determined by state law.
The basic probate steps are:
An individual or entity (often named in the will) petitions the probate court to become the legal representative of the estate
The legal representative (executor or administrator) notifies heirs and creditors of the death
The legal representative takes possession of the deceased individual’s assets
The legal representative pays funeral expenses, taxes, and debts
The legal representative transfers remaining assets to the heirs
The legal representative notifies the court of its actions and requests that the estate be closed.
Practically speaking, probate involves a great deal of administrative legwork and can be quite costly. Some describe being an executor as having a second job for a period of months — or, in some cases, years. You can find out more by reading our articles on the probate process and on the duties of an executor.
Many individuals seek to avoid probate for their loved ones by removing assets from the jurisdiction of the probate court. An asset that doesn’t go through probate transfers automatically to its intended beneficiary without any of the hassle of the probate process. To learn more about probate assets and non-probate assets, read our article on what type of assets pass through probate.
Does life insurance go through probate?
An up-to-date life insurance policy does not have to go through probate. Because a beneficiary is designated within the policy, the life insurance is paid out directly to the beneficiary upon the death of the policy owner.
Unfortunately, many life insurance policies are not up to date.
If the beneficiary listed on the policy is deceased, unable to be located, or if there is no listed beneficiary, the policy often must go through probate so that the court can determine who can legally claim the benefit. If the beneficiary is a minor, the court may need to appoint a guardian, a process that would require probate even if the policy itself does not.
When a life insurance policy has to go through probate, there are administrative headaches. But there are bigger reasons to keep that policy out of the probate process.
As we described in the probate steps above, debts and taxes must be paid before assets are distributed to heirs. So if a life insurance policy goes through the probate process, it will be used first to pay any remaining debts or taxes before the remainder gets distributed to any intended beneficiary.
Conversely, the funds in a life insurance policy that flows directly to a designated beneficiary are not readily available to estate creditors — a pretty good reason to make sure a policy doesn’t go through probate.
How to avoid probate through beneficiary designations
We’ve already established that avoiding probate is a time- and money-saver. So how can you make sure that a life insurance policy doesn’t go through probate? Properly designate beneficiaries.
We’ve provided some guidelines:
A beneficiary must be alive.
One of the most common mistakes people make is failing to update a beneficiary designation on a life insurance policy after the death of a spouse. For instance, a husband and wife list each other as beneficiaries on their life insurance policies. The husband dies, and the wife receives the life insurance proceeds. But she never updates her life insurance policy. When she dies, her (now deceased) husband is listed as a beneficiary and there is no alternate beneficiary listed. Because he is not alive to receive the benefit, the life insurance proceeds must go through probate.
A beneficiary must be over the age of 18.
If the listed beneficiary is a minor, the court would need to name a guardian to manage the benefits until the beneficiary reaches the age of majority. There is a way to get around this — by naming a trust created for the minor as beneficiary of the policy.
A beneficiary designation cannot be changed through a will.
For instance, Joe named his sister as his life insurance beneficiary. Several years later, he wrote a will stating that all of his assets should go to his girlfriend. He dies, and his girlfriend wants to claim his life insurance benefit as part of his assets. The proceeds of the life insurance policy will go to the sister because beneficiary designations are completely separate from wills.
Designating a contingent (alternate) beneficiary provides protection.
Listing a second option reduces the possibility of a policy having to go through probate because the intended beneficiary is not available because of death, minor status, or failure to be reached.
Updating policies after divorce helps prevent unintended consequences.
If a divorced individual failed to change their beneficiary designation prior to their death, the proceeds of their life insurance policy could end up going to their ex-spouse. In some states, divorce triggers an automatic revocation of the ex-spouse as designated beneficiary on a life insurance policy. If that revocation occurs and the owner of the policy does not update the designation, the policy will be left without a beneficiary. In that case, the policy proceeds may have to go through probate.
The most important thing to remember is to keep your beneficiary designations up to date. Check them periodically, and make sure to update them after major life events such as a divorce, marriage, or death of a loved one.
What if a life insurance policy must go through probate?
Despite our best intentions, we all make mistakes sometimes. So what happens if the owner of a life insurance policy dies, and there is no available beneficiary to receive the death benefit?
The policy must go through probate as part of the deceased’s estate.
As part of the decedent’s estate, these funds become subject to payment of taxes and debts, if they remain, or for distribution to heirs.
Some states exempt a portion of the life insurance benefit from debt or tax collection, but the amounts are generally fairly low.
How life insurance impacts estate taxes
A life insurance policy with up-to-date beneficiary designations does not have to go through probate and thus does not get used to paying things like income taxes. However, estate taxes are a different matter. The cash value of a life insurance policy purchased and owned by the deceased is included in that individual’s taxable estate and is subject to state and federal estate taxes.
Most people won’t have an estate large enough to surpass the federal estate tax exemption, which is $12,060,000 in 2022. But someone could find themselves unexpectedly in that bracket if they don’t count their insurance policy. For instance, if an individual believes their estate will be exempt because it’s valued at $10 million, and they have a $3 million death penalty payable to the estate, they may have to pay estate taxes on the amount over $12,060,000.
Some states have their own estate tax that kicks in at lower thresholds, and life insurance proceeds (that are part of a decedent’s gross estate) will be subject to state estate tax also.
Claiming a life insurance benefit
While the probate process can be long and time-consuming, filing a claim for the death benefit from a life insurance policy is relatively straightforward. The designated beneficiary must contact the insurance company and will likely need a certified copy of the death certificate.
Once the claim is approved, the insurance company will cut a check directly to the beneficiary.
At Trust & Will, we’re here to help you keep things simple. You can create a fully customizable, state-specific Estate Plan from the comfort of your own home in just 20 minutes. Take our free quiz to see where you should get started, or compare our different estate planning options today!
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