Life Insurance is a unique estate planning tool, because you pay relatively little up front, and your beneficiaries get much more when you die. When you name beneficiaries other than your estate, the money passes to them directly, without probate. If most of your money is tied up in non-liquid assets like your company or real estate, life insurance gets cash into your beneficiaries’ hands without their having to resort to a fire sale of other assets.

Though procedures vary by company, usually the beneficiaries receive their insurance proceeds promptly. Generally, the beneficiary informs the company in writing of the death, sends a copy of the death certificate, and receives a check, often within a few weeks.

Three Ways to Distribute Proceeds

If you own life insurance on your own life, you can have the proceeds distributed in three ways.

1. To beneficiaries. The company pays the proceeds directly to one or more beneficiaries named in your policy. This is the quickest way to get the money to your survivors, and the proceeds typically pass free of income tax. However, your estate may be liable for federal and state estate taxes if the proceeds when added to the other assets in the estate, total more than the $675,000 threshold at which the federal estate tax presently kicks in.

2. To your probate estate. If you choose this route, the proceeds will be distributed along with your other assets according to the terms of your will. (If you die without a will, your state’s intestate succession laws will determine where the proceeds go.) However, they will be subject to the probate process, and may add to the cost of probate by making the estate larger, and will be subject to creditors’ claims. In addition, they may be subject to estate tax. You should do this only if your estate won’t otherwise have enough money to pay debts and taxes.

3. To an irrevocable trust. If you make the proceeds payable to an irrevocable trust – either one set up in your will or created during your lifetime – they will be distributed like the other trust assets. Paying the proceeds to such an irrevocable life insurance trust has several advantages:

Who Should Own the Policy?

As noted above, if you own the policy, the proceeds payable on death will be included in your estate for tax purposes. What with the soaring stock market and a boom market for homes, adding the proceeds of life insurance might push a lot of folks beyond the $675,000 limit. Fortunately, there are several ways of using life insurance to save taxes.

If your life insurance is payable to your spouse, it won’t matter in the short run if it pushes the value of your estate above $675,000 – gifts of any size between U.S. citizen spouses pass tax-free. But when your spouse dies, his or her estate is liable for taxes on anything over the threshold, so in effect that estate pays a delayed tax on the insurance proceeds.

To escape estate taxes on the proceeds, you must see that the policy is not owned by you or your estate. There are two common ways to do this:

Third Party Owners. In the first method, your children take out a policy on your life that benefits them or, alternatively, you transfer an existing life insurance policy on your life to your children and they name themselves as beneficiaries.

You can give them the money each year to pay the premiums, making sure to keep your total gift to each person at or below $10,000 per year to avoid the gift tax. A new policy- or an existing policy, provided you live more than three years after transferring ownership- is out of your estate and thus escapes estate taxes.

Life insurance trusts are a popular way of accomplishing the same goals. You set up an irrevocable life insurance trust in which the trust owns the policy on your life – not you. The trust can buy a policy on your life, or you can transfer ownership of an existing policy to the trust (though in the case of a transfer, you would have to live at least three years for the proceeds to escape estate taxation.) Each year, you pay the premiums so the policy stays in effect. When you die, the policy pays death benefits to the trust, and these benefits are free of estate taxes. Your family including your spouse, can live off the income from the trust and has certain rights regarding the principal. Upon your spouse’s death, the trust terminates and the children take the principal remaining, again free of estate taxes.

Life insurance trusts are only one example of using irrevocable trusts to create a tax-free estate. Your lawyer can explain many other options.