How Life Insurance Works with Wills and Trusts
Your last will and testament and your life insurance are both necessary parts of your financial plan. Both a will and testament and life insurance can help support your loved ones after you die by providing them with the resources they need to pay their expenses.
Life insurance pays a death benefit to any person or organization you name as a beneficiary on your policy. Your last will and testament distribute the assets in your estate to the beneficiaries you name in the will. In both cases, the beneficiary can be a trust, which owns the asset until the beneficiaries of the trust are allowed to access it.
Can I use my will to distribute a life insurance death benefit?
You can’t use your will to modify or cancel your life insurance policy. That means that if you named someone as a beneficiary of your life insurance, that person would remain the beneficiary after you die, and the death benefit will be paid out to him or her.
The will directs probate, the legal process by which assets are distributed according to the will; the value of any assets not specifically bequeathed to the beneficiaries of your will must be divided up among all the beneficiaries of the will. With one exception (see below), your life insurance’s death benefit doesn’t go through probate, meaning that the terms of the will don’t govern it because it already has an assigned beneficiary.
Life insurance is not an asset in the traditional meaning of the word. That’s because you don’t receive the death benefit while alive unless your policy allows you to use part of it to pay for end-of-life care. (The accelerated death benefit rider offers this feature.) You’re paying premiums so that your heirs can have an asset: the death benefit.
Since premiums are typically low and death benefits typically very high, life insurance is a great way to leave money for your family if you’re concerned that your estate may not suffice.
When life insurance does go through probate
When you write a will, you’re creating a legal document that distributes the assets in your estate. The life insurance death benefit is not intended to be part of your estate because it is payable on death – it goes directly to the beneficiaries in your policy when you die.
(Your life insurance has both primary beneficiaries, who get paid first, and contingent beneficiaries, who get paid if the primary beneficiaries are no longer alive or can’t be located.)
But if all your beneficiaries have predeceased you, then the life insurance death benefit is paid out to your estate. That means it will be distributed to the beneficiaries of your will depending on the terms of the will. You can also choose your estate as the beneficiary. Note that if your life insurance pays out to your estate, your creditors may be able to get part of the death benefit.
If you don't have a will, now's a good time to look into getting one.
If the death benefit value is over $11 million, your estate may also have to pay federal estate taxes on it. (Some states also impose an inheritance tax.) Additionally, if the death benefit increases the value of your estate above the threshold, it could cause your estate to owe taxes when it would have otherwise been exempt. For that reason, you should always update the beneficiaries of your life insurance policy – death benefits paid directly to the beneficiary are not taxed if you paid the premiums with your after-tax earnings.
Does my life insurance need to have the same beneficiary as my will?
No, your will and your life insurance do not need to have the same beneficiary. The exception is if you live in a community property state, in which case your spouse is entitled to receive both the life insurance death benefit and the assets of your estate.
Putting the life insurance death benefit in a trust
Trusts have specific rules that dictate who can access the assets in the trust and when. Unlike a will, assets in a trust are usually not subject to probate, and they are owned by the trust (not your estate) until they’ve been distributed.
You can use your last will and testament to establish trust and place any or all assets into the trust. You can also use it to move assets into a revocable trust you’d already established while alive.
With life insurance, your options are more limited. You can’t use your life insurance to establish a new trust, but you can designate an already-existing revocable trust as your beneficiary. If there are terms in the trust specifically governing how the trust’s beneficiaries spend the death benefit, then those terms will go into effect once the death benefit funds it.
Irrevocable life insurance trust
An irrevocable life insurance trust (ILIT) only holds life insurance policies. With an ILIT, you pay the premiums associated with the policies and the fees for administering the trust out of cash assets owned by the trust. When you die, the death benefit is paid to the ILIT, and its proceeds are distributed to the beneficiaries named in the trust.
However, you must make sufficient deposits to the trust’s cash-assets account to cover administration fees as well as policy premiums. For that reason, ILITs are only recommended if you are already considerably wealthy and you are trying to avoid paying the estate tax.
Otherwise, ILITs are not the best choice for most people. You may have a stronger return on investment by paying for a low-cost term life insurance policy and investing your assets into a retirement account. You can list beneficiaries on your retirement account (as well as your deposit accounts, like your checking or savings), or you can choose for them to go through probate via your last will and testament.