Because of its flexibility, tax advantages, and potential to leverage your assets, life insurance can be an important estate planning tool. The usefulness of life insurance in almost any estate plan of any magnitude makes it one of the most universally applied tools. There are three major reasons:
- Creating an immediate estate. For the price of a premium, even someone with no savings - like a newlywed or young parent - can quickly create a sizable estate with the potential to provide for the needs of dependent survivors. Of course, premiums vary according to type of policy and the amount of coverage purchased, so needs and affordability are issues every applicant for life insurance must contend with. But one of the great advantages of a life insurance policy is that most of the benefits paid out by the policy can be received tax-free.
- Providing liquid proceeds for final expenses. Unlike wills, cash distributions from life insurance normally aren't required to pass through probate. As a result, beneficiaries can have more timely access to pay for such final expenses as unpaid bills, funeral expenses, and taxes.
- Keeping post-tax asset values intact. Even with the recent increase in the U.S. estate and gift-tax exemption to $5 million for individuals and $10 million for married couples, some estates will still be large enough to be subject to taxes. In a properly structured estate, the tax-free death benefit of a life insurance policy can be used to offset the taxes beneficiaries must pay, essentially allowing them to receive the benefit of the full value of the assets.
Planning Considerations
There are a host of issues to decide upon when considering the role that life insurance can play in your estate plan. First among them is determining the coverage amount and type of policy, which - even for a young family or one with fairly simple estate planning issues - can be quite complicated. But there are many other decisions to make, including:
- Who owns the policy? The policy's owner does not have to be the person who pays the premium. Who it is, however, can have important ramifications for the tax treatment of death benefits. For example, the death benefits from a policy owned by a business controlled by the person insured may be subject to estate taxes. On the other hand, ownership by the surviving spouse can merely delay estate taxes until the death benefits pass to the couple's children.
- Who are the beneficiaries? Is it the surviving spouse, the children, other relatives, a business or business partners, or a legal entity, like a trust? Again, the wrong choices can confound the purposes for which you buy the policy in the first place.
- Should a trust be involved? To avoid the pitfalls of ownership by the wrong person or entity, you can create an Irrevocable Life Insurance Trust, or ILIT, as both the owner and the beneficiary. In this case, death benefits are generally distributed tax-free. To ensure that is the outcome, the trust must be properly structured - a trustee, a settlor, and beneficiaries must all be properly named, and their roles regarding payment of estate taxes must be carefully defined.
- How should your policy be coordinated with other trusts? If your estate issues are more complicated than average, you may find your plan involves other trusts, like a qualified personal residence trust (QPRT), which involves the ownership of your dwelling by your beneficiaries, or a Qualified Terminal Interest Property Trust (QTIP), which is typically used when one spouse wants to ensure the distribution of assets after the remaining spouse's death. Each of these trusts can benefit from the way you structure the life insurance component of your plan, so coordination with your policies can be advantageous.
What role should life insurance play in your estate plan? Only a thorough analysis can provide the answer that's right for you. Please call if you'd like to discuss this in more detail.