What role does life insurance play in an estate plan?

What role does life insurance play in my estate plan? Is it part of my taxable estate and is it subject to probate?

This is an important conversation to have. It is so important, in fact, that the column will address some of the considerations of life insurance in two parts, so be sure to check in next month for part two.

First, you must make a distinction between a “probate estate” and a “gross taxable estate.” Probate is the process in which your will is admitted and approved by the court. Probate assets are collected by the Executor and subject to the claims of your creditors. Typically, you would not want your insurance proceeds payable to your estate. Life insurance is transferred to your beneficiaries by a designation of beneficiary form properly filled out and delivered to your insurance company. In other words, regardless of what your Last Will and Testament says, if your beneficiary designation on a life insurance policy says something different, it will pass to the individual(s) identified on that designation form.

Similarly, although New York State law provides for the severance of beneficiary designations to a spouse upon divorce, that rule does not necessarily apply to certain pension plans. You must take care to update your beneficiary designation forms to ensure that they are current and consistent with your intentions.

Life insurance can serve different purposes for different people. Among the common purposes of life insurance are:

1. To provide your loved ones with immediate liquidity to pay estate taxes and funeral expenses until your estate is administered through probate or a trust. This is especially helpful where an estate consists primarily of illiquid assets like real property, artwork, or even wine collections.

2. To equalize beneficiaries who have received other assets (say, the family business), or to leave disproportionate assets to beneficiaries if that is your intention.

3. To “buy out” a business partner, so that you need not remain in business with your partner’s spouse when your partner dies, if you cannot afford to buy your partner’s shares in the business from his or her estate.

4. To pay any outstanding mortgages or maintain properties until other assets can be liquidated, to avoid having to sell the asset in a down-market or in a “fire sale.”

5. To ensure that your beneficiaries have funds available to pay other potential future tax liabilities, such as estate, annual estate income, or capital gains taxes.

There is a common misconception that insurance is not taxable in your estate. If you own an insurance policy, or have the incidents of ownership (i.e., the right to change the beneficiaries on the policy), then the entire insurance proceeds would be taxable in your estate when you die. A taxable estate includes both probate and non-probate assets. Assets which avoid probate do not necessarily avoid estate taxation. In addition to insurance owned by the decedent, IRAs and other retirement assets, annuities, joint bank accounts, and other joint interests may avoid probate and pass directly to your beneficiaries but they are still included in the estate for estate tax purposes.

If estate taxes are a problem, you can create an insurance trust which owns the life insurance policy, which I will discuss in next month’s column. As noted above, life insurance also provides a way to equalize bequests to beneficiaries or to provide additional funds to certain beneficiaries. For instance, if your estate plan provides for one of your children to take over a family-run business, you can use life insurance to achieve an equitable result by naming those children who are not involved in the business as beneficiaries. Conversely, you may want to provide for your children equally in your Will, but provide additional funds to a particular child through the use of life insurance.

Before purchasing a life insurance policy, you should give careful consideration as to who will be listed as the owner of the policy. There is a common misconception that life insurance proceeds are not taxable in your estate. However, if the insured person owns an insurance policy, or has “control” over the policy, (i.e., the right to change the beneficiaries on the policy), then the death benefit of the policy will be added to the value of the insured person’s estate, and may therefore be subject to estate taxes. In contrast, if the policy is owned by someone other than the insured, then the insurance proceeds will not be included in the insured person’s taxable estate. There are other planning techniques that may allow you to transfer an existing life insurance policy to another person or to an irrevocable trust and potentially avoid future estate taxes for those insurance proceeds provided you live an additional period of three years after the transfer of the policy.

As you can see, there are many potential benefits of life insurance. In order to figure out the benefits to your particular estate plan, you should consult with your estate planning attorney, financial advisor, and insurance agent.

Alison Arden Besunder is the founding attorney of the law firm of Arden Besunder P.C., where she assists new and not-so-new parents with their estate planning needs. Her firm assists clients in Manhattan, Brooklyn, Queens, and Nassau and Suffolk Counties. You can find her on Twitter @estatetrustplan and on her website at besunderlaw.com. If you have a question that you would like to see answered in this column, please email alison@besunderlaw.com.