Estate planning attorneys are often asked if a particular asset will be included in an estate, from life insurance and real estate to employment contracts and Health Savings Accounts. The answer is explored in the aptly-titled article, “Will It (My Home, My Life Insurance, Etc.) Be in My Estate?” from Kiplinger.
When you die, your estate is defined differently for different planning purposes. You have a gross estate for federal estate taxes. However, there’s also the probate estate. You may also be considering whether an asset is part of your estate to be passed onto heirs. It depends on which part of your estate you’re focusing on.
Let’s start with life insurance. You’ve purchased a policy for $500,000, with your son as the designated beneficiary. The entire $500,000 death benefit will be included in your gross estate for federal estate tax purposes if you own the policy. If your estate is big enough ($12.06 million in 2022), the full death benefit above the exemption is subject to a 40% federal estate tax.
However, if you want to know if taxes will include the policy in your probate estate, the answer is no. Proceeds from life insurance policies are not subject to probate since the death benefit passes by contract directly to the beneficiaries.
Next, is the policy an estate asset available for heirs, creditors, taxing authorities, etc.? The answer is a little less clear. Since your son was named the designated beneficiary, your estate can’t use the proceeds to fulfill bequests made to others through your will. Even if you disowned your son since naming him on the policy and changed your will to pass your estate to other children, the life insurance policy is a contract. Therefore, the money is going to your son unless you change this while still living.
However, there’s a little wrinkle here. Can the life insurance policy proceeds be diverted to pay creditors, taxes, or other estate obligations? Here the answer is, it depends. An example is if your son receives the money from the insurance company, but your will directs that his share of the probate estate be reduced to reflect his share of costs associated with probate. If the estate doesn’t have enough assets to cover the cost of probate, he may need to tap the proceeds to pay his share.
Another aspect of figuring out what’s included in your estate depends upon where you live. In community property states—Arizona, California, Idaho, Louisiana, New Mexico, Nevada, Texas, Washington, and Wisconsin—assets are treated differently for estate tax purposes than in states with what’s known as “common law” for married couples. Also, in most states, real estate owned on a fee simple basis is transferred on death through the probate estate, while in other states, an alternative exists where a Transfer on Death (TOD) deed is used.
This legal jargon may be confusing, but it’s essential to know because if a property is in your probate estate, expenses may vary from 2% to 6%, versus assets outside of probate, which have no expenses.
Speak with an experienced estate planning attorney in your state of residence to know what assets are included in your federal estate, your probate estate, and what taxes will assess on your estate by the state or federal governments. Don’t forget; some states have inheritance taxes your heirs will need to pay.
Reference: Kiplinger (Dec. 13, 2021) “Will It (My Home, My Life Insurance, Etc.) Be in My Estate?”