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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. Your estate planning attorney and life insurance agent will work with you to help you achieve your goals.

Life insurance can replace an income stream, preserve assets, and/or 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.

A simple calculation is to take the amount of income you want to replace and multiply it by the number of years you want to replace it. If you will be replacing your income, keep in mind that there will be no personal expenses for you—food, clothing, travel, insurance, taxes on your income—if you are not here. So instead of using the amount you earn, use the amount you actually contribute to your household. If the person to be insured is a stay-at-home parent and does not earn an income, estimate how much will be needed to pay someone to take over those responsibilities. You can use the same general calculation to determine how much insurance you need for other purposes.

Now, how long will you want to replace this income or provide this support? If you have young children, you probably want to provide for your family until they are grown and out of college. You may want your spouse to have enough to last until he/she can collect Social Security and other retirement benefits. You may want to provide for an elderly parent for as long as he or she is expected to live, or replace a key employee for just a couple of years.

As an example, let’s say you are 40 and you want life insurance that will provide for your family for 25 years. Take the amount of annual income you want to replace, multiply by 25 (number of years), and multiply again by an assumed rate of inflation—that’s how much life insurance you want. This amount, called the face value or death benefit, may be a pretty big number. So, now the issue becomes how much life insurance you can afford, and that will depend, in part, on the kind of life insurance you purchase.

Basically, there are two kinds of life insurance: term and permanent. (Permanent can include sub-categories like whole life, universal life, and variable universal life, but we will keep to a basic explanation of term and permanent.)

Term life insurance covers you for a set number of years, or a term. It is pure insurance, and is similar to the insurance you have on your car or home. It can be a good choice if you want coverage for a certain number of years—for example, until your kids are out of college or your mortgage is paid off. It is also generally less expensive than permanent insurance and is least expensive when you are young and healthy. For these reasons, term life insurance is a popular choice for young families.

Permanent life insurance, on the other hand, does not expire at the end of a specified term (assuming you continue to pay the premiums, of course). Generally, the coverage stays in effect during your lifetime and the premium, depending upon the type of policy, can either stay the same or fluctuate based upon the financial performance of the policy. Permanent policies also build cash value over time that can be borrowed from the policy (reducing the proceeds paid at your death), used to help pay the premiums, or refunded to you if you cancel the policy.

Depending on your needs and what you can afford, you may decide to go with some combination of the two. In any event, the amount you pay for life insurance must be an expense you can live with. Buying life insurance to provide for your family for 20 or 25 years may be out of the question, even with term insurance. A viable alternative is to cover five to seven years of expenses, which will give your family time to adjust and cope with your absence.

Be a careful consumer when buying insurance. You want to choose a reputable company that will be around when you die and will be able to pay the benefits. Look for a company that has top ratings from ratings companies like A.M. Best, Moody’s, and Standard & Poor’s.

Remember that illustrations are just that—illustrations. Premiums are based on your age, health, and assumed interest rates. If interest rates fall below a certain level, the insurance company may increase your premium. Check that the interest rates used in the illustrations are realistic. Also, some policies reduce the death benefit if you live beyond a certain age. Make sure you know how much the policy will pay, regardless of your age when you die.

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.

That said, life insurance proceeds are generally included in your estate for estate tax purposes. With the federal estate tax exemption currently at more than $5 million, this is not a concern for most people. But if the amount of your life insurance pushes you beyond the federal estate tax exemption (or beyond your state’s exemption), your attorney will probably recommend that you have an irrevocable life insurance trust for your insurance policies.

If you are single and your net estate, including life insurance, is more than the federal estate tax exemption, or if you are married and your total net estate is more than two exemptions, an irrevocable life insurance trust can reduce your estate taxes.

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%.

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.

Alternately, you could have another person (like your spouse or an adult child) own your insurance for you. That would keep it out of your estate but you would not have as much control over the policy. This person could change the beneficiary, take the cash value, or even cancel the policy. With an insurance trust, the trustee you select (it must be someone other than you) must follow the instructions in your trust.

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.

Existing policies can be transferred into an insurance trust, but if you die within three years of making the transfer, the death benefits of the policies will be taxed as part of your estate. There may also be a gift tax.

The trustee can also purchase a new policy, but it must be done in a special way so you don’t incur a gift tax. Each year, you can make an annual tax-free gift to each beneficiary of the insurance trust. But instead of giving this money directly to the beneficiaries, you give it to the trustee for them.

The trustee then notifies each beneficiary that a gift has been received on his/her behalf and, unless the beneficiary elects to receive the gift now, the trustee will invest the funds—by paying the premium on the insurance policy. Of course, for this to work, the beneficiaries must understand not to take the gift now. (By the way, the written notification to the beneficiaries is known as a “Crummey letter,” named after the man who first tested it with the IRS.)