Estate planning is a crucial process that allows individuals to plan for the transfer of their assets to their loved ones after they pass away. However, many people overlook the role of life insurance in their estate plans. Estate planning with life insurance can provide various benefits that help individuals maximize the value of their estate and minimize their tax liabilities.
In this article, we will define estate planning with life insurance and explain why it is essential to incorporate a life policy into your estate plan. We will also provide an overview of the benefits of using life insurance for estate planning purposes, including liquidity for estate expenses, equalizing inheritances among heirs, and protecting assets and income for surviving dependents.
Whether you are just starting your estate planning journey or looking to update your existing plan, this article will provide valuable insights into leveraging your life policy to achieve your goals.
Understanding Estate Planning with Life Insurance
There are three central considerations to bear in mind when considering estate planning with life insurance:
- The types of life insurance policies and their features;
- The role of beneficiaries in estate planning with life insurance;
- The differences between revocable and irrevocable life insurance trusts.
Insurance Policies
Understanding the different types of life policies and their features is essential when planning for your estate. The two primary types of life insurance are term and permanent life insurance.
Term Life Insurance
Term life provides coverage for a specified period of time, such as 10 or 20 years. The beneficiaries will receive a death benefit if the insured passes during the policy term. A term life policy is typically cheaper than a permanent one, making it an attractive option for those needing coverage for a specific period, such as parents with young children or someone with a mortgage.
Term life is as ‘basic’ as a policy can be without any cash value outside of the paid benefits assigned to beneficiaries after the policyholder’s passing.
Permanent Life Insurance
Permanent policies offer bolstered coverage. They cover the policyholder’s entire life as long as they’ve paid all their premiums and the policy is in force.
Permanent life insurance policies offer more than only death benefits. They also accumulate cash value over time, which the policyholder can access and use during their lifetime. The availability and functionality of these “before death” benefits depend on the type of policy: whole, universal, or variable.
By comparison of their features, permanent policies offer more wealth-building opportunities.
Naming Your Beneficiary
Determining the beneficiaries is the first step in estate planning with life insurance. These individuals will receive the death benefit when the policyholder passes away. Review and update the beneficiary designation when required to ensure the intended recipient gets the benefits. You also have the option of adding contingent beneficiaries.
Furthermore, considering the tax implications of naming certain beneficiaries, such as non-spouses or minors, is essential. We will delve further into this topic later in the article.
Revocable and Irrevocable Life Insurance Trusts
When incorporating life insurance into your estate planning, you must also decide whether to use a revocable or irrevocable life insurance trust. A revocable life insurance trust (RLT) allows the grantor to modify or terminate the trust at any time.
In contrast, once established, the grantor can’t change or withdraw an irrevocable life insurance trust (ILIT). ILITs offer exclusion to the life insurance proceeds from the grantor’s taxable estate, giving them more control over how they distribute their death benefit and inheritance among heirs.
Understanding the types of life insurance policies, beneficiaries, and trusts available can help you make informed decisions about structuring your estate inheritance plan with a life policy. In the next section, we will review how life insurance can maximize the benefits of your estate-building plan.
Maximizing Benefits with Life Insurance in Estate Planning
When it comes to estate planning with life insurance, there are several ways to maximize the benefits of your policy. Here are some common strategies to consider and why.
- Using life insurance to pay estate taxes: Estate taxes can significantly burden your heirs, but life insurance can provide the funds to cover these expenses. By designating the policy’s death benefit to pay estate taxes, you can preserve your assets for your beneficiaries.
- Providing liquidity to pay for estate settlement costs: Besides federal taxes, there may be other associated expenses with settling your estate, such as legal fees and funeral costs. Life insurance can provide the cash needed to pay these bills, allowing your estate to avoid the potential for forced asset sales.
- Equalizing inheritances among heirs: If you have multiple heirs, you may want to use life insurance to ensure that each receives an equal inheritance. For example, if you plan to leave your family business to one child, you can use life insurance to provide an equivalent share to your other children.
- Business funding and asset protection: If you’re interested in starting a business, life insurance can serve as collateral for a loan. Your policy can fund a buy-sell agreement if you have a business partner. This contract stipulates the terms and process by which the surviving partner can buy the deceased’s shares.
- Protecting assets and income for the surviving spouse and dependents: The death benefit proceeds can also protect your spouse and dependents from financial hardship in the event of your death. By designating them as beneficiaries, you can ensure they have the financial resources to maintain their standard of living.
- Meet debt obligations: As an added incentive, the death benefit can help clear outstanding debts. You may live in a common law state where the living spouse becomes responsible for debt payments, or you have a co-signer on the loan. Your coverage will take the pressure off them.
- Offer long-term care: Medical bills and long-term care are costly expenses. With permanent, cash-value life insurance, you can ease the financial burden on your family by tapping into the policy’s funds to take care of expenses rather than your life savings.
- Charitable giving with life insurance: If you’re passionate about supporting a particular charity, you can use life insurance to make a significant impact. By designating the charity as the beneficiary of your policy, you can ensure that your legacy lives on in the causes you care about.
- Provides Peace of Mind: A comprehensive estate plan with life insurance can alleviate any anxiety about the financial safety of your loved ones in your absence. It’s how you can set things in place before the inevitable happens. With their security assured, you can focus on what matters most, like spending time in the present with your family instead and enjoying life instead of worrying about the “what ifs.”
Utilizing estate planning in tandem with your life policy can safeguard your assets and loved ones, guarantee the execution of your desires, and offer assurance for you and your loved ones.
Minimizing Taxes with Life Insurance in Estate Planning
Federal Estate tax rates can lead to a significant chunk of your estate funneling into tax payments instead of your heirs. With proper planning beforehand, they may avoid ending up with estate tax issues that sabotage the goal of passing on wealth.
Life insurance can offset potential critical issues and minimize tax burdens.
Estate Taxes and Their Impact on Your Estate
The payable taxes on your estate depends on your estate’s total value at the time of your death. Depending on the size of your estate, these taxes can be a significant financial burden for your heirs, with rates as high as 40%. Here’s how it all breaks down.
The estate tax applies to the value of your assets, including retirement accounts, real estate, investments, and life insurance policies.
Adding life insurance to the list might seem out of place since the proceeds from a policy incur no income taxes. But they may become part of your taxable estate for estate tax purposes. However, life policies are only included in your taxable estate if you don’t take steps to remove them, such as using a life insurance trust or gifting the policy. Let’s discuss strategies for avoiding taxation on your policy.
Strategy #1: Transferring Ownership
When you transfer ownership of a life policy to another person or entity, you relinquish control of the policy and its benefits. The new owner assumes responsibility for paying the policy premiums and receives the policy’s death benefit upon your passing.
Benefits:
- Transferring ownership of the policy removes it from your taxable estate, potentially reducing the impact of estate taxes.
- The annual gift tax exclusion permits you to gift up to a specific amount each year to each recipient without incurring gift taxes. You can gift up to $17,000 per recipient as of 2023, so the new owner can use some of that funds to pay the premiums.
A Note on Gift and Estate Tax Exemptions
The IRS sets a new gift tax exclusion each year, which allows taxpayers to make tax-free gifts up to a certain amount to each recipient without exhausting their lifetime gift and the applicable exclusion exemption amount.
For 2023, the annual gift tax exclusion threshold is $17,000 per recipient, up from $16,000 in 2022. The limit increases the overall lifetime gift and estate tax exemption for individuals to $12.92 million and $25.84 million ($34,000 per recipient) for married couples filing jointly. [Source: IRS]
Downsides:
- You must make the transfer at least three years before your death to avoid the policy being subject to estate taxes.
- You give up all rights, so you can’t change details on the policy once the insurance company confirms the ownership change.
- Ownership is irrevocable, so be mindful of whom you list as the new owner. You can’t reclaim the policy in the event of a divorce.
Ensure you receive a confirmation letter about the transfer from your life insurance company, and keep the document safe.
Strategy #2: Insurance Trust
Another method of excluding life insurance proceeds from your taxable estate is by setting up an irrevocable life insurance trust (ILIT), which involves transferring ownership of the policy to the trust.
Why ILIT
The ILIT proves to be an effective instrument for estate planning as it prevents the imposition of federal estate taxes on assets that do not meet the criteria for charitable or marital deduction. If the policyholder transfers an active policy to an ILIT, they must survive for at least three years from the transfer date to prevent the policy’s inclusion in their gross estate.
Criteria for Setting Up an ILIT
As the grantor, you cannot serve as the trustee and must relinquish all rights to revoke the trust to complete the transfer. By doing so, the trust will hold the policy, and it’s no longer part of your estate, exempting the proceeds from estate taxes. The ILIT’s trustee will become the policy’s owner and beneficiary.
Selecting trust ownership instead of transferring ownership to another individual may be advantageous for several reasons.
- You retain some level of legal control over the policy.
- A trust ensures timely payments of premiums.
Moreover, if the policy’s beneficiaries are minor children from a previous marriage, using an ILIT allows you to designate a trusted family member as the trustee to oversee the funds on behalf of the children according to the terms of the trust agreement.
This overview is a simplified breakdown of what an irrevocable life insurance trust entails. For an in-depth understanding of how the provisions may apply to you, seek legal advice from a qualified estate attorney.
Choosing the Right Life Insurance Policy for Estate Planning
Policy Features
Choosing the right life insurance policy is the first step in the estate planning process. Here are the top points to consider when selecting a life policy:
- Policy features: Different types of policies have varying features and benefits, so it’s essential to understand the policy’s details and how they align with your estate planning goals. Researching and consulting with a reputable agent will help with your selection.
- Premiums: Consider how much you can pay in premiums and whether the policy’s premium structure is sustainable over the long term. Estate planning is a marathon, not a print. Pacing your funds will help you maintain momentum and reduce the likelihood of your policy lapsing.
- Insurer’s financial strength: Ensure the insurer is financially stable and has a stellar reputation for paying claims. The quality of your insurer serves as a guarantee that there won’t be any (or few) disruptions on their end for the life of the policy, and your funds for beneficiaries remain protected.
- Underwriting process: Underwriting varies among insurers and policies, so it’s necessary to consider the process’s speed and thoroughness.
- Flexibility: Look for policies that offer flexibility regarding coverage and premium payments.
Additional Reading:
Here are some of our previous posts for reference.
Determining Your Coverage for Estate Planning
Your required coverage amount depends on your circumstances. It’s a numbers game that revolves around several factors.
- Outstanding debts: Consider any outstanding debts you may leave behind upon passing. Is your family or a co-signer on the hook for repayment? Do you have a business loan or other business-related debts? How much will you need to square off those debts?
- Estate and inheritance taxes: Determine the potential estate taxes and if your state also requires the payment of inheritance taxes. Ensure the policy’s death benefit is sufficient to cover these taxes and administrative costs while leaving a sizeable insurance benefit amount.
- Income replacement: Consider the income your family will lose upon your passing and tailor your policy to provide funds for daily living expenses for a certain period while they adjust.
- Other expenses: Consider any unavoidable payments upon passing, such as funeral costs and outstanding medical costs. What other additional costs might your loved one face?
The math will change over time.
One of the most unpredictable factors you’ll face is inflation. Inflation refers to the fluctuating increases in the prices of goods and services, which can erode the value of a country’s currency over time. As a result, you must consider the impact of inflation on your estate planning, including life insurance policies.
Inflation increases the cost of living and the capital needed to maintain the same standard of living. Because of this, it affects the value of your life insurance policy’s death benefit, decreasing its buying power over time. To account for this change, you may consider purchasing a policy that offers an inflation-adjusted death benefit, which will increase the policy’s death benefit to keep pace with inflation.
You may see an increase in annual interest rates outside of the death benefits. As the cost of living increases, insurance companies will need to charge higher premiums to maintain the same level of coverage. Review your life policy periodically and compare it with others from different companies to ensure you get the best coverage at the most affordable price.
Weighing the Benefits of Term vs. Permanent Coverage
When comparing term vs. permanent life insurance for estate planning purposes, consider the following:
- Term life is more affordable than permanent insurance and provides coverage for a specified period, broken up into 10, 20, or 30 years.
- Permanent life insurance covers the policyholder’s entire life and accumulates cash value over time, which makes it generally more expensive than term life insurance.
- Permanent life insurance policies can be used for estate planning, as they accumulate a cash value usable to pay estate taxes or provide income replacement for beneficiaries.
- Term life insurance policies work for estate planning purposes, particularly for younger policyholders who may not need the coverage for their entire life.
The right life insurance policy for protecting your assets and loved ones will depend on your unique financial situation and goals. Working with a financial professional is vital to choose the appropriate coverage amount and policy type that aligns with your estate planning goals.
Working with an Estate Planning Attorney
For the best results, work with a licensed estate planning attorney. An estate planning attorney will help you navigate complex legal and financial issues and provide valuable guidance on structuring your estate plan to maximize life insurance benefits.
Here are some of the ways an estate planning attorney can assist you:
- Choosing the Right Life Insurance Policy: An experienced attorney can help you review your options and pick the right type and amount of life insurance coverage to meet your goals. They can also help you understand the differences between term and permanent insurance and how they fit into your estate planning strategy.
- Structuring Your Estate Plan: Your attorney can assist you in structuring your estate plan to maximize life insurance benefits. They can help you create trusts and other legal structures to protect your assets, minimize taxes, and ensure that your beneficiaries receive the death benefit according to your wishes for the distribution of assets.
- Updating Your Estate Plan: Estate planning is an ongoing process, and it’s essential to update your plan regularly to reflect changes in your life circumstances and the tax and legal landscape. An estate planning attorney will help you reassess and update your strategy to ensure that it continues to meet your needs and goals.
This post was for informational purposes and a guide toward sourcing the right help. Working with an estate planning attorney is key in making informed decisions about life insurance and other aspects of your estate plan. An attorney will provide invaluable guidance and expertise to assist you in achieving your goals and protecting your loved ones’ financial future.
Conclusion
Estate planning with life insurance can provide many benefits, including safeguarding your loved ones, asset protection, minimizing taxes, and ensuring the fulfillment of your wishes. By choosing the right life insurance policy, understanding the different types of trusts, and working with an estate planning attorney, you can create a comprehensive estate plan tailored to your unique needs and goals.
Don’t delay until it’s too late to start planning for your future. Take action today and consult with an estate planning attorney to create a personalized estate plan and reap the benefits from life insurance for the peace of mind of you and your loved ones.
