When life insurance proceeds are paid to an estate they are taxable. The proceeds become a part of the estate and are considered when calculating taxes on its value.
Continue reading to learn how this happens and why most advisors recommend you avoid this scenario, as well as a few tips to help you keep life insurance proceeds out of your estate.
Life insurance proceeds are not usually paid to an estate. In most cases, the life insurance company pays the beneficiary the death benefit directly after the death of the insured.
The money moves directly from the life insurance company to the beneficiary, and it does not transfer through the possession of the insured. This means that, regardless of who the policyholder is, the life insurance proceeds are not part of the assets of the insured.
In certain cases, the proceeds can be paid to the estate.
The first is when the life insurance policy lists the estate of the insured as the beneficiary. This method is generally not recommended.
The other time life insurance proceeds end up in the estate is when the beneficiary is unable to accept the payment. This happens most often when the beneficiary dies before the insured and the policy is not updated. Naming a contingent beneficiary can prevent this from happening.
The Canada Revenue Agency (CRA) does not charge a specific estate, inheritance, or death tax, but there are other taxes and fees taken out of the estate that should be considered.
Despite the lack of a specific tax on death, the estate is still on the hook for covering these costs.
When life insurance proceeds are paid directly to the beneficiary there are no taxes owed on that amount. The only chance of taxes is if there is an increase in value due to interest, but this does not apply to the death benefit portion of the payment of proceeds.
When life insurance goes into the estate it is now included when calculating the end of life costs, so estate taxes are applied to the amount of the life insurance policy proceeds.
It is generally recommended and preferred to keep life insurance proceeds out of the estate. Beyond a desire to keep the sum tax-free, life insurance proceeds paid to the estate increase its value and are inaccessible during the probate process.
Taxes can diminish what is paid out of a life insurance policy considerably. When it becomes an asset it is assumed to have been sold for fair market value at the time of death, alongside any real estate, land, investments, and RRSPs.
The value of the life insurance policy proceeds are then treated as income, and the amount must be included on the final tax return prepared and filed by the executor.
This also means that the value of the policy is considered when determining what tax bracket the estate is gauged by. Life insurance policies tend to be large enough to drastically change the financial situation of an individual.
Even smaller policies can incur the highest tax rate, decreasing what is inevitably paid out to the heirs of the estate.
Depending on where you are located, the probate fees can also increase with the estate value. Some provinces, like Quebec, do not charge probate fees. Others, like Ontario, charge based on the value of the estate. When you are dealing with thousands of dollars the addition of a life insurance policy can increase these fees considerably.
Assets of the estate cannot be released until the probate process is completed, and the timeline for this is inconsistent.
For reference, it can take 3 months before an application for probate is seen in court, and the entire probate process is known to take up to a year. If there are complex situations or debts the process can last even longer.
During this time families are without the funds and support of the deceased. They are unable to use the life insurance proceeds to pay for:
Without access to life insurance proceeds, family members may need to return to work sooner than they are emotionally prepared to cover existing expenses. The need to hire additional help for childcare or housekeeping can increase their expenses.
To keep the life insurance proceeds as far from taxation as possible you must keep them out of the estate. The easiest way to do this is by listing a beneficiary that is not the estate.
Setting up a contingency plan that includes a secondary beneficiary is also helpful in case you are unable to or forget to update the life insurance policy as needed.
Those that name the estate as the beneficiary may be trying to distribute life insurance proceeds among multiple individuals, but this is not necessary.
Many life insurance policies allow you to name more than one beneficiary for the policy. The full amount of the death benefit will be divided amongst the beneficiaries you have named, so there is no need to send it to the estate for the executor to distribute.
If you do not have anyone you want the policy to go to then you can name a charity as the beneficiary, or you can surrender the plan for the cash value instead of allowing it to default to the estate.
If you have one person that you want the life insurance proceeds to go to, then consider setting up a contingency plan. The contingency plan allows you to create a second beneficiary that the life insurance policy can pay out to if the first is deceased. Click here, for additional information on what happens if the beneficiary of an estate dies.
While this can help in a scenario where the policy was not updated after the death of the initial beneficiary, it can also provide support for another family member if the beneficiary passes at the same time as the insured.
There are many different aspects to consider when setting up your estate, and keeping life insurance proceeds from becoming taxable is only one of them. Contact Sim Gakhar for help setting up a life insurance policy in a logical way.
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