Life insurance is about protection, making sure your loved ones have resources to help continue on after your passing. But life insurance can also help with estate planning and the management and distribution of your assets.
How? Passing on an estate can involve numerous issues, depending on your personal circumstances and the amount of assets at hand. The strategic use of life insurance can help with:
When you pass, your loved ones may face some expenses. These can include:
- Funeral expenses. The median cost of a funeral is more than $7,000, according to a trade association. Adding the cost of a vault for burial adds even more to the bill. (Related: Funeral costs and considerations)
- Some debts. Your debts become your estate’s responsibility when you die. As a result, those debts may reduce the assets that remain for your heirs. (Related: What happens to your debts when you die?)
- Final income taxes. The government requires payment of any back taxes, plus any taxes owed for the year you die. (Related: Death and taxes)
Life insurance can help cover these costs as well as provide a source of funds for beneficiaries to use to meet other obligations, without having to tap estate resources or assets. This can be especially beneficial if the estate holds real estate or other assets that can’t easily or quickly be converted to cash.
“I find the vast majority of a retiree’s assets are in retirement accounts and home ownership,” said Doug Collins, financial planning director for Fortis Lux Financial in New York City. “Both retirement accounts and homes can be difficult to turn into liquid cash. A house that is left to multiple siblings can be difficult to handle for financial and emotional reasons — you cannot sell or retain your childhood bedroom without selling or retaining the whole house. A retirement account will be counted as taxable income to the beneficiary and must be taken out within the first ten years by any non-spousal beneficiary, which could impact taxes for your beneficiaries for a decade.”
Collins pointed out that a life insurance policy death benefit can solve many of these problems, such as providing instant liquidity to one or more children, without having to quickly sell a family home or paying the tax that would be owed on an inherited retirement account.
Also, life insurance proceeds are generally not subject to income taxes.
There may be taxes due on an inheritance, depending on the size of the estate. How much and at what rate has been somewhat of a moving target over time.
For instance, in 2021, up to $11.7 million of an inheritance is exempt from federal taxes and amounts over that level get taxed at a rate of 40 percent. But in 2017, the exemption was only about half that, at $5.49 million. Twenty years before that, in 1997, the exemption stood at $600,000 and the inheritance tax rate was 55 percent.
And the threshold could change further. The current exemption, which is indexed for inflation, will expire in 2025 unless renewed by Congress.
“The potential for higher federal estate or income taxes adds up to the need for more efficient tax planning when discussing a legacy,” said Jeffrey Rotman, principal of the wealth management firm Rotman & Associates in Fort Lauderdale, Florida. “Life insurance can play a key part in that as death benefits are passed on tax free. In particular, cash value life insurance deserves strong consideration, not only due to the income-tax free death benefit, but also because of the cash value itself, which can serve liquidity purposes while alive and enjoys tax-deferred growth.”1
Beyond the federal estate tax question, some states impose inheritance taxes as well.
Life insurance proceeds can be used to help offset whatever taxes may be due on an inheritance. This can help beneficiaries avoid instances where estate assets have to be sold to cover tax obligations.
What if there are multiple heirs to an estate, but assets aren’t that easily split up?
For a hypothetical example, what if a mother dies and leaves a beach house worth $600,000 to two sons and a daughter. The sons live far away and want to sell it immediately. The daughter desperately wants to keep it. To compensate the sons — and avoid a family rift — the daughter would have to compensate them $400,000. What if she doesn’t have the money?
In instances like this, life insurance in an estate plan can be used to fill the gap and equalize an estate inheritance among heirs. In this example one heir, the daughter, would get the beach house while the sons would receive death-benefit proceeds.
This tactic is often used when passing on farms, where breaking up the operation would have negative consequences on its revenue generating ability. (Related: Keeping a farm in the family)
If you are a business owner or co-owner, your passing could present challenges for those continuing the business after you, whether it’s family or business partners. Proceeds from a life insurance policy can help ease that situation. (Related: 3 reasons an entrepreneur needs life and disability income insurance)
Indeed, many partnerships and start-up enterprises establish plans from the outset to handle the loss of an individual with knowledge or talents key to the overall undertaking. This is often handled through the establishment of a buy-sell agreement — a contract that outlines how a departing founder or partner’s share in a business should be sold or reassigned to other stakeholders. Life insurance is often used to fund such an agreement. (Related: Funding a buy-sell agreement)
Special purposes: Divorce, child support, more
Additionally, life insurance proceeds can be earmarked for a specific purpose, like divorce obligations for spousal or child support. Or, death-benefit proceeds can be dedicated to continuing support for a loved one, like a minor, a child with special needs, or an aging adult.
These types of directed purposes are often handled through the establishment of a trust. These kinds of arrangements hold assets on behalf of a beneficiary under the supervision of a trustee. A life insurance policy can fund a trust for a specific purpose, like continuing alimony payments, supporting a child until a certain age, or paying for care for a loved one with special needs. (Related: Is setting up a trust right for you?)
There are many types of trusts with advantages and disadvantages regarding taxes, probate, and other matters. Many people opt to consult a financial professional about the options and how they might apply to personal circumstances and goals.
Probate is the process for overseeing the settlement and distribution of a decedent’s assets. It tends to be a lengthy and involved process, even when there is a will and general estate plan in place. (Related: Why people fear probate)
Insurance proceeds, however, avoid probate when going to a named beneficiary. And the payment can remain private, whereas the probate process is public.
These are just a few of the more common uses of life insurance in estate planning. There can be many more uses, as wide and varied as the different circumstances and goals of one individual from another.
That’s why many people opt to consult a financial professional about the possibilities. (Need a financial professional? Let us know)
Life insurance is a useful tool for estate planning. But, like any tool, it takes a little know-how to use it properly.
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1 Tapping into the cash value of a life insurance policy reduces its value and death benefit and increases the chance the policy will lapse. And if a policy lapses with an outstanding loan in excess of the cost basis, it’s taxable. And in that event, taxes are due on any gain in cash value, including borrowed cash value.