Life insurance is a versatile estate planning tool – much like a Swiss Army Knife.
Estate planning requires more than a life insurance policy.
A life insurance policy does not designate guardians, executors, or financial and healthcare agents.
A last will and testament, trusts, and power of attorney documents are required to provide these protections.
Used in conjunction with these documents prepared by an experienced estate planning attorney, a life insurance policy can help you achieve your estate planning goals and meet the specific needs of your loved ones.
Why would incorporating life insurance into your estate plan be important?
Part of creating a comprehensive estate plan is addressing financial vulnerabilities.
These include estate taxes, administration costs, funeral arrangements, and creditor payments.
Such policies can also provide immediate liquidity for the beneficiaries to pay for daily living expenses.
In short, only life insurance can create an “instant estate” when your life is cut short of building an estate for your loved ones.
Although life insurance is the cornerstone of financial and estate planning, various policies exist.
The type of policy you choose should align with your specific goals and needs.
Generally, term life insurance provides temporary coverage, while whole life insurance is permanent.
The former is akin to “renting” and the latter to “owning” the policy.
For this reason, understanding this element will help align the policy with your estate plan.
How Can Life Insurance Be Used in Estate Planning?
Life insurance can fulfill numerous roles in estate planning.
Heirs may have various financial burdens associated with your death.
Perhaps these include immediate needs, like funeral costs and other debts.
If you have a large estate subject to state or federal estate taxes, a life insurance policy can protect the home or other valuable tangible property from being sold to pay this tax bill.
How Does One Choose the Type of Life Insurance to Purchase for Estate Planning?
Your goals and needs will guide the type of insurance you choose.
Do you have minor children and want to ensure they are cared for until age 18?
If yes, a term life insurance policy may be sufficient.
This policy covers death benefits for that set period.
Do you need permanent coverage to build cash value, provide an inheritance to adult heirs, cover estate taxes, or meet other estate planning goals?
These strategies would be more effective with a whole life or universal life insurance policy.
When choosing the policy amount, you should consider how it will impact your estate overall and what will be received by your heirs.
An insurance professional can help you determine whether a term or permanent life insurance policy suits your specific needs and goals.
In my own case, I took out a sizeable “convertible” term life insurance policy when my children were young, based on the premium amount I could afford.
I needed that large death benefit in case “something happened” to Kyle.
Over the years, however, I have converted that term insurance to permanent insurance for additional financial security and cash liquidity for Gretchen.
You see, I “do eat my own cooking” when it comes to financial and estate planning.
How Does Life Insurance Provide for Heirs?
The death of a partner or provider leads to the potential financial vulnerability of dependents or spouses.
This is true whether the deceased individual was the breadwinner or the homemaker.
Life insurance can provide financial security and support to beneficiaries after you die.
Policies can help ensure your spouse, children, or other dependents continue to have a roof over their heads and food on the table, let alone higher education and (first) weddings.
Life insurance policies can provide immediate funds to pay bills if much of the family wealth is tied up in a home, retirement accounts, or a business.
Because you will not be around to benefit from the policy, consider the needs of your heirs and their capability of handling a large influx of money directly when creating your estate plan.
Who Should Be Listed as the Life Insurance Beneficiary?
Who is designated as the beneficiary can work for or against your comprehensive estate plan.
If your goal is to help your spouse pay bills after you die, then you may want funds designated directly to your spouse.
If your goal is to protect the college education of your children, you may want to make a trust the beneficiary with stipulations for the funds to be used for education.
Because life insurance beneficiaries receive the death benefit directly, they will have access to the funds before the finalization of the probate proceedings.
The beneficiaries listed on the policy will receive the funds from the insurance company.
For this reason, you need to review and update designations regularly to ensure the desired heirs inherit when and how you intend.
Take speedy action after a marriage, a death, a divorce, or the birth of a child to avoid unintentionally disinheriting a loved one while simultaneously giving an ex a significant windfall.
Although many people consider individuals first when considering beneficiaries, trusts can also be named beneficiaries of insurance policies.
What are the Role and Benefits of a Life Insurance Trust in Estate Planning?
One of the most popular life insurance trusts is an irrevocable life insurance trust (ILIT).
ILITs place the life insurance policy within the created trust.
By using the policy to fund a trust rather than providing an outright inheritance to heirs, you can maintain greater control and direction over the distributions to beneficiaries.
In addition to maintaining greater control of the distributions, an irrevocable life insurance trust removes the policy from your estate because the trust owns it.
As a result, you can lower your estate tax liability.
Additional benefits of ILITs include providing inheritances for a child with special needs, creating additional protective barriers against legal judgments or creditors, and protecting the payout solely for the chosen beneficiaries.
Irrevocable life insurance trusts require professional planning and must meet specific legal guidelines.
The trustee you name will need to be another individual or organization.
The responsibility of this trustee is to manage the trust and to distribute the life insurance death benefit according to the terms outlined in the trust.
Do I Need to Consider Federal Estate Taxes when Purchasing Life Insurance?
Life insurance policies are often strategically used to provide liquidity to account for federal estate taxes when the estate exceeds the tax exemption threshold.
In general, life insurance policies will not be taxed as federal income, so the full amount could be used to pay the estate taxes.
Rather than having to sell larger assets like a home to secure funds to pay state and federal taxes, the death benefit from the policy could be used.
Depending on how the policy is owned, you may find the policy will be included in the gross estate for determining estate tax liability.
You could accidentally bring your estate value over the exemption threshold without considering these factors.
If you could be subject to estate taxes with the addition of a life insurance policy, an ILIT may be recommended by your estate planning attorney to remove this wildcard from your taxable estate.
Discuss your circumstances with your tax advisor and experienced estate planning attorney to anticipate and account for tax liabilities.
What are the Connections Between Life Insurance and Estate Planning?
The type of life insurance policy you choose should work with your comprehensive estate planning goals.
Because beneficiary designations govern the distribution of the death benefit rather than the terms of a last will, you should review and update policy designations regularly.
A life insurance trust can provide greater protection and control over the proceeds of the life insurance policy.
Although life insurance can account for estate tax liabilities, it can also create them when proper planning has been disregarded.
Life insurance can help you provide financial security for your loved ones in the wake of your death.
Working with a life insurance professional, a CPA, and an experienced estate planning attorney allows you to maximize life insurance benefits for your loved ones strategically.