Life Insurance in Estate Planning
Part of the estate planning process includes reviewing the amount of life insurance you currently have and determining if more is needed to provide for your family the way you want.
The Many Uses of Life Insurance in Estate Planning Life insurance can replace an income stream, preserve assets, and create wealth for your dependents after you die. For example, life insurance proceeds can be used to:
- Pay final expenses, including medical, funeral, burial/cremation, etc.
- Pay off credit cards and other debts/loans
- Pay off a mortgage
- Replace the income you contribute to the household.
- Continue care for those for whom you provide care: your spouse, aging parents, children, pets, siblings, and others who depend on you
- Pay college expenses for your children or grandchildren
- Provide funds to replace a stay-at-home parent
- Provide for a surviving spouse's retirement, medical, and possible long-term care expenses. Replace wealth following a sizeable charitable gift during life
- Provide funds for a private (family) charitable foundation
- Provide funds for a trust for future generations (dynasty trust)
- For business owners, fund a buy-sell agreement so that when one owner dies or becomes disabled, the other is able to buy the deceased owner's share of the business from his/her family
- For business owners, create an inheritance for all children, including those not working in the family business
- For business owners, fund a key man policy, insuring the life of an employee or partner who has a critical role in the business. If this person dies, money would then be available to continue the business while a replacement is found
- If your estate is sizeable, life insurance can be used in a variety of planning techniques to create cash to pay estate taxes and fund other needs
Life insurance proceeds are not subject to income taxes and were designed to be paid immediately in cash to the beneficiary upon the death of the insured without having to go through probate. However, if the beneficiary designation is not valid or the beneficiary is a minor, incapacitated or deceased at the time, or if the beneficiary is "my estate," the proceeds will have to go through probate court proceedings.
For most people, it is best to have your living trust be the owner and beneficiary of your policies. This will give you more control over the proceeds than if they are paid to an individual beneficiary. Also, proceeds that are kept in a trust are protected from a beneficiary s creditors (bankruptcy and divorce proceedings), predators (those with undue influence) and irresponsible spending.
Life insurance proceeds for which you have any "incidents of ownership" (policies you can borrow against, assign, or cancel, or for which you can revoke an assignment, or name or change the beneficiary) are included in your taxable estate when you die. Currently, every dollar over the federal exemption is taxed at 40%.
To avoid estate taxes on life insurance proceeds we recommend that you have an irrevocable life insurance trust for your insurance policies. Very simply, a life insurance trust owns your insurance policies for you. And because you don't personally own the insurance, it will not be included in your taxable estate. This makes your estate smaller—so it will pay less in estate taxes and more of your estate will go to your family.
An insurance trust also gives you more control over how the proceeds are used. For example, you could direct the trustee to make the funds available to pay taxes and other final expenses. You could provide your surviving spouse with a lifetime income and keep the proceeds out of both of your estates. You could also keep the proceeds in trust and provide periodic income to your children or other loved ones—without giving them the full amount.