Is life insurance part of your estate?

Your estate includes anything you own—your money, property, investments and other belongings—along with any debts you owe. However, it's not a given that everything you own and pass on to others will be subject to estate tax when you die. 

Whether life insurance is part of your taxable estate depends on how the contract is structured and who the beneficiaries are. To create an effective estate plan, it's important to understand these differences.

Usually, life insurance has a death benefit that can skip probate when it's set up to be paid directly to a named beneficiary. It's designed that way so your heirs or loved ones aren't waiting on a lengthy court process to get money they might need to cover expenses right away. 

In those cases, the life insurance benefit is paid outside the estate. Life insurance proceeds are typically income‑tax free for beneficiaries, though state inheritance tax still may apply.

However, that doesn't mean life insurance is never part of an estate.

Life insurance can be included in the estate when beneficiary or ownership issues arise. A revocable living trust named as beneficiary does not, by itself, keep proceeds out of the estate; ownership and control are what matter. An estate attorney can help you address these common situations:

• The estate is named as the beneficiary.
• The life insurance doesn't have a beneficiary or the named beneficiary died before the insured person without having a backup. (This is why it's a good idea to have a secondary or contingent beneficiary if you can.)
• At the time of death, the insured person had ownership—including the right to change beneficiaries or borrow against or surrender the policy—or held a joint or business ownership interest.
• The life insurance contract had been transferred within three years before the death.

Life insurance creates an immediate estate in the sense that the death benefit—regardless of who it's paid to—increases the inheritance the person has to pass along to their loved ones. 

Here's a simplified example to illustrate: Suppose a single parent's main asset is their house, and they want to leave it equally to their two adult children. They anticipate that one child will want to keep the house while the other will want to sell it. 

The "immediate estate" created by life insurance can help both children get what they want. With a death benefit that approximates the home's future value, the person could leave 50% of the house and 50% of the life insurance payout to each child. Then, if one wants to buy the other's share of the house so they can keep it, they can.

Usually, life insurance does not go through probate as long as there is a named beneficiary alive to receive the death benefit. If proceeds are payable to the estate, however, they become subject to probate.

Assets left to the estate, to heirs in a will or to no one in particular must go through probate, a process overseen by the state courts. Probate can be undesirable due to time and cost.

Some states have simplified probate procedures for small estates, but most estate cases go through a standard process that's subject to the court's schedule and workload. If there are any disputes, probate can drag on for months or years while decisions are made. Even in a straightforward estate, fees for legal consulting, accounting and appraisals can add up. 

To be sure about how your life insurance proceeds will be handled, talk to your insurer, financial advisor and/or estate attorney. 

Before assuming you need to rely on life insurance for estate planning, it's important to review your assets and liabilities, consider who might need your support and find out what means they have to provide for themselves.

Naming beneficiaries on life insurance isn't the only way to provide funds to loved ones without the delays or costs of probate. Any asset that allows beneficiary designations can work this way, including retirement and certain other financial accounts.

Going back to the previous example, the parent with the house and two children would want to be sure to coordinate any life insurance planning with other estate planning documents. A will or trust can help ensure assets are distributed the way the parent wants. 

Life insurance proceeds sometimes can trigger estate tax considerations—especially when the payout is directed to or benefits the estate itself. This often happens when life insurance is used to cover estate debts, including estate taxes.

If an estate tax return is required, it must include any life insurance on the decedent's life, even if those proceeds aren't technically part of the gross estate. That reporting requirement can surprise families who assumed the life insurance was outside the estate's scope.

Estates that exceed the federal estate tax exemption must file a return. If an estate tax return is filed, it must list any beneficiary who receives life insurance proceeds.

Also, if the estate is required to file a return, any life insurance payable to or benefiting the estate must be reported on Schedule D of IRS Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return.

Life insurance typically pays your beneficiaries directly and avoids probate. In certain cases, such as when no living beneficiary is named or the estate is the beneficiary, life insurance may be subject to probate. Aside from probate, there are also estate tax considerations, and life insurance payouts may be reportable. 

It's important to consult an estate attorney if you have any questions about what may be considered part of an estate. Professionals like a Thrivent financial advisor also can help you understand how life insurance factors into your overall financial strategy and goals.