Be Careful Relying on Life Insurance to Provide for Loved Ones

In an estate plan, life insurance can be used as a source of immediate liquidity for beneficiaries by offering a tax-free, lump-sum payment upon the insured’s death.

About half of Americans have a life insurance policy. The primary reason people purchase life insurance is to fund burial and other final expenses. However, a policy can help pay for much more, such as replacing lost income, paying off debts, equalizing inheritances, and funding a trust.

Most life insurance policies provide flexibility in how the death benefit is paid, but policies do not actually pay out in every situation. If you have life insurance policy coverage, you need to understand the scenarios that can nullify it to ensure that your loved ones receive the financial protection the policy is intended to provide.

How Life Insurance Works

The following key players are involved in a life insurance policy:

The policyholder is the person who owns the policy and pays the premiums.
The insured person is the person whose life is covered by the policy.
The beneficiary is the person or entity designated to receive the death benefit when the insured person dies. The beneficiary can be an individual, a trust, a charity, or a combination of multiple beneficiaries.

The insured person may or may not be the same person as the policyholder.

Life insurance is a contract between the policyholder and an insurance company (the insurer) in which the insurer agrees to pay a death benefit to designated beneficiaries upon the insured’s death in exchange for regular premium payments.

Types of Policies

The three main types of life insurance are permanent life, term life, and employer-provided life insurance.

Term life insurance offers coverage for a specific period of time (term), with a death benefit paid out only if the insured dies within that time frame.
Permanent life insurance provides coverage for the insured’s entire lifetime and builds cash value over time, typically with higher premiums than term life insurance. There are two main types of permanent life insurance: whole life and universal life.
Employer-provided life insurance is a policy offered by an employer to their employees and paid for by the employer. The employer is the policyholder, and the employee is the insured. In many cases, the death benefit will be paid only if the insured is still working for the employer on the date of their death.

Payout Structures

Life insurance is usually paid out as a single lump sum, in installments over time, or through a life insurance annuity. The payment options available depend on the terms of the individual policy and the issuing insurance company. Some permanent life insurance policies also allow the policyholder to access cash value through withdrawals or loans while the insured is alive.

Lump sum. The most common payout method is a lump-sum benefit paid to the beneficiary in a single payment.
Installments. The death benefit is distributed in regular payments over a set period.
Life annuity. The death benefit is used to purchase an annuity, providing a stream of income to the beneficiary for a specified duration.

Life Insurance and Taxes

Beneficiaries generally receive a life insurance payout tax-free, although there are some cases when a death benefit is taxable.

For example, if the payout is set up to be made in installments rather than in a lump sum, the principal is not taxed but any interest that accrues is taxable. The death benefit may also be subject to estate taxes if the total estate value exceeds the estate tax threshold and the insured person was also the policyholder.

The Importance of Designating the Right Primary and Contingent Beneficiaries

One major benefit of having life insurance with a designated beneficiary as part of an estate plan is that the death proceeds bypass the court-supervised probate process.

However, the death benefit can unintentionally go to the estate in the following situations:

The policyholder fails to designate beneficiaries.
Named beneficiaries predecease the insured.
Beneficiaries cannot or will not accept the death benefit.

This is why it is essential to name primary and backup beneficiaries and carefully consider whom you name for these roles.

Even if the policyholder names beneficiaries, the death proceeds may still become the subject of a probate court proceeding if the designated beneficiaries include minor children or adults who lack mental capacity. Because such individuals cannot legally own assets (property or accounts), a judge may have to appoint someone to manage the death benefit until the beneficiary becomes an adult or can manage it themselves. So even if a beneficiary is designated on a life insurance policy, it is important to consider who that beneficiary is and what the legal consequences of passing assets on to them would be.

What Life Insurance Can Be Used For

A life insurance beneficiary can use the money however they want. It is generally received tax-free, without restrictions on how it can be spent. Even special types of life insurance, such as final expense insurance that is meant to help pay for funeral and burial expenses, can generally be used for any purpose by beneficiaries.

However, you also can set up your estate plan to guarantee that life insurance proceeds are used for a specific purpose. You can do so by naming a trust as the life insurance beneficiary and listing those specific instructions in the trust document.

Life insurance can also be used for the following purposes:

Pay off mortgages and other debts. Life insurance proceeds can be used to pay off the remaining balance on your mortgage, a credit card or personal loan, or other outstanding debt.
Fund a trust for your minor child. Minors are not eligible to receive life insurance funds directly. Instead, the money can be directed to a trust that benefits them and is overseen by a trustee. The trust can cover future needs like education costs and living expenses.
Fund a special needs trust. This type of trust is often established for the benefit of a disabled child or individual and funded through a life insurance policy. It can be structured so that the trust pays only for qualified expenses that do not impact eligibility for means-tested government benefits, such as Medicaid.
Fund a trust for your surviving spouse. Proceeds from a life insurance policy can also be placed in a trust that benefits your surviving spouse. The death benefit can replace your lost earnings and provide your spouse with financial support.
Equalize inheritances. You may wish to leave an equal value of money and property to each of your children. If you have property that cannot be easily divided, you can give it to one child and name your other child as the beneficiary of a life insurance policy of a substantially equal amount.
Ensure business continuity and succession plans. For business owners, a life insurance policy can fund a buy-sell agreement to pay for your share of the business at your death so there is a smooth ownership transition and business continuity.
Cover estate taxes and settlement costs. Few estates are subject to the federal estate tax due to the current high exemption amounts. However, you might owe income taxes when you die, and some states have their own estate tax and an inheritance tax. There may also be probate fees and court costs. Life insurance proceeds can provide liquidity to pay these taxes and fees without having to sell or liquidate other accounts and property.

In addition, life insurance proceeds can be designated for a certain purpose, including a spousal or child support obligation. Like death benefit proceeds that support a minor child or beneficiary with special needs, death benefits with a directed purpose are best handled through the establishment of a trust.

Why Life Insurance May Not Pay Out

Life insurance is a contract that comes with terms and conditions. Some conditions, called exclusions, allow the insurer to deny payment to beneficiaries when the insured dies. The following are common life insurance policy exclusions:

Expired policy. Term life insurance will not pay out past the policy’s stated term. It may be possible to renew and extend the policy term, however.
Leaving a job. Employer or group life insurance is usually dependent on employment, so coverage ends when an employee leaves their job.
Risky activities. The insurance company may be able to deny a death benefit if the insured died while taking part in risky activities such as skydiving, rock climbing, and scuba diving that are specifically excluded in the policy contract. Certain jobs, such as logging, offshore oil work, and law enforcement, may also fall under this category.
Illegal activities. An insured’s death that occurs while they are engaging in an illegal activity or committing a crime is usually an excludable event.
Suicide. Life insurance generally covers death by suicide, but most policies have a “suicide clause” that exempts suicide occurring in the policy’s first two years or a different time frame as defined in the contract.
Murder. Murder, like suicide, is generally not excluded from life insurance coverage. However, if a beneficiary murders the insured, they will not receive the death benefit; it passes instead to contingent beneficiaries.
Substance abuse. A policy may exclude deaths resulting from drug or alcohol abuse, including overdose deaths.
Lying on the application. Life insurance companies decide whether to issue a policy and how much to charge based on the information the insured provides. Not providing accurate information constitutes a material misrepresentation—and insurance fraud—that can allow an insurer to rescind coverage.

Importantly, an insurance company might provide coverage to individuals who engage in risky behaviors or have a high-risk health status (e.g., alcohol and drug use, a family health history of disease, or a diagnosed medical condition) but may charge them higher premiums. Lying about this information on an application could lead to a denial of benefits.

Also, exclusions can change over time according to changing norms. For example, insurers historically excluded aviation accidents from coverage, but this is no longer common practice since private aircraft are now much safer. It is crucial to review the fine print of an insurance policy and understand its exclusions and key terms.

An estate planning attorney can provide guidance about how to integrate life insurance into your plan in a way that meets your financial and legacy goals, whether those goals are to fund trusts with life insurance proceeds, cover estate and income taxes, fund a buy-sell agreement, or provide overall estate liquidity and financial peace of mind. Schedule a consultation to learn more.