A life insurance policy payoff is part of the policy owner’s private contract with the insurance company. It should promptly go to the named beneficiaries with no probate court involvement, upon proof of the insured’s death. Death benefit payments from a policy owned by the decedent to a named beneficiary are excluded from the probate estate. The proceeds are also excluded from the beneficiary’s federal and state income tax almost everywhere. In most states, life insurance proceeds paid to a named beneficiary enjoy greater protection from claims of the decedent’s creditors than is given to other property that passes outside the probate process.

If the decedent owns a policy on his or her life, the proceeds are includable in the decedent’s federal taxable estate, even though the cash is paid income tax-free to the named beneficiary. Naming one’s estate as beneficiary also creates potential estate tax liability. Many people are surprised by this, because we generally think only of the roles of the insured person and the beneficiary when considering life insurance. But it makes sense if one keeps in mind that an insurance policy is simply an asset. The policy owner exercises his or her rights of ownership by choosing to whom the payoff will go.

Many persons are unaware that their estates may exceed the federal estate tax credit (equivalent to $3.5 million in 2009 but removed during 2010) because the value of their life insurance is added to their other assets, resulting in a hefty tax bill. Tax on life insurance proceeds can be easily avoided with careful estate planning. This often involves creating an irrevocable trust to own the policy.

Life insurance is a very important and useful financial and estate planning tool. To avoid undesirable tax consequences, however, one must consider the manner in which the policy is owned.