What Happens to Life Insurance When the Insured Dies?
Life Insurance Proceeds and Probate
Life insurance inheritances go directly to the beneficiaries who are named on the policies. They typically don't become part of the decedent's probate estate, so you should be spared the headache of probate.
Inheriting life insurance can bring tax and other consequences, however, and it occasionally happens that the company refuses to pay out at all.
How to Collect a Life Insurance Inheritance
You can collect policy death benefits by sending the original death certificate and the original life insurance policy to the insurer if you're named as the beneficiary. More commonly, the insurer will provide you with a claim form upon notification of the decedent's death.
The company will transmit the money directly to you. It doesn't go to or become part of the policy holder's probate estate, although it can contribute to the decedent's gross estate for estate tax purposes.
You may have no idea that you are entitled to death benefits after the death of a certain person you know. There are ways to find out if you are in for a pleasant surprise.
When There's More Than One Beneficiary
Some policies name more than one individual to receive the death benefit proceeds when the insured dies. The money is normally divided equally among them when this is the case.
Should one beneficiary predecease the insured, that individual's share would normally pass to any other named beneficiaries to be shared equally among them. The deceased's estate would take the proceeds only if none of the policy's beneficiaries are living.
Why an Insurer Might Not Pay
It's possible for an insurer to refuse to pay out benefits under some circumstances, but generally only if the policy provides for it.
Insurers will generally not pay out when the deceased has committed suicide within the first two years. They might also decline to pay if the insured smoked, regularly engaged in and died engaging in dangerous activities such as drag racing, or died during the commission of a crime.
All these terms are typically spelled out in the policy, but health-related issues can be tricky. Maybe the deceased didn't smoke at the time he took out the policy, but then he started. Insurers can refuse to pay out benefits if the policy was conditioned on the insured not being a smoker.
The same can apply to undivulged health conditions, such as high blood pressure or cancer, but the insurance company would most likely have to prove that the insured was aware of the condition at the time the policy was taken out if and wasn't diagnosed for the first time years later.
Income Tax Consequences
You don't have to pay income tax on the initial policy proceeds when you're the beneficiary of a life insurance policy. The Internal Revenue Service doesn't consider death benefits to be income.
Any interest earned by the proceeds would be taxable, however, if the policy earns income after the date of death. This might happen if you don't take the benefits in one lump sum but rather stretch them out in installments over a period of years. The balance retained by the insurer would keep growing, so you'd be taxed on that additional interest.
The same would happen if you took all the proceeds at once and plunked the money down in a savings or investment account. Any interest or dividends earned would be taxable income.
You must include this income on your tax return just as you would report any other interest or unearned income you received during the tax year.
Inheritance Tax Consequences
There's no inheritance tax at the federal level, but six states do impose this tax as of 2020: Nebraska, Iowa, Kentucky, Pennsylvania, New Jersey, and Maryland.
This isn't an income tax, but rather a percentage of the value of the assets you inherit.
Some states that do have inheritance taxes, such as New Jersey, specifically exempt life insurance proceeds from taxation.
Estate Tax Issues
Life insurance proceeds contribute to the value of a decedent's taxable estate if the decedent was the owner of the policy or if the decedent transferred ownership within three years of death, such as into an irrevocable living trust.
A decedent's estate is liable for federal estate taxes if it's valued at more than $11.58 million as of 2020. Any balance of value over this threshold is taxable. Twelve states and the District of Columbia also impose estate taxes as of 2020, some with much lower exemptions. Those states and their exemptions are:
- Connecticut: $5,100,000
- District of Columbia: $5,760,000
- Hawaii: $5,490,000
- Illinois: $4,000,000
- Oregon: $1,000,000
- Maine: $5,800,000
- Maryland: $5,000,000
- Massachusetts: $1,000,000
- Minnesota: $3,000,000
- New York: $5,850,000
- Rhode Island: $1,580,000
- Vermont: $4,250,000
- Washington: $2,193,000
There's a sizable difference between the $11.58 million federal exemption in 2020 ($11.7 million in 2021) and the $1 million exemption that's available in Oregon and Massachusetts.
Beneficiaries of life insurance proceeds are not usually responsible for paying the estate tax, however, unless the decedent's last will and testament contains specific provisions asking them to contribute some of the death benefit proceeds to satisfy the tax burden.
The Insured's Final Bills
The named beneficiary on a policy generally isn't required to use any of the death benefit proceeds to pay off the decedent's debts. The probate process typically pays the deceased's creditors and final bills from estate funds and, if necessary, by liquidating estate assets.
Life insurance proceeds that go directly to a named beneficiary never become part of the decedent's probate estate, so the money isn't available to creditors. Beneficiaries have no legal obligation to use the money to satisfy the decedent's debts unless they also happen to be cosigners on the loans.
Related: Best Whole Life Insurance Policies
Spouses can additionally be held responsible for some medical bills in community property states.