The Role of Life Insurance in Estate Planning

More Than Just a Safety Net

Life insurance sounds like a last resort for protecting your loved ones. But did you know that it actually comes with tax and wealth protection opportunities? Many families underestimate how well life insurance fits into estate planning.

In this guide, we will discuss how you can gain opportunities to protect wealth, avoid unnecessary taxes, and provide financial security for future generations through life insurance.

Why Life Insurance Matters in Estate Planning

Financial protection

Life insurance ensures that your dependents have income and stability after your death. This is particularly crucial if you are the sole or main income earner of your family.

If your dependents do not have a stable income source or have a disability, life insurance is also an incredibly useful way to provide financial support without preventing your loved ones from obtaining certain government benefits.

For example, people with disabilities may be ineligible for valuable government support if they inherit too many assets. By implementing a Special Needs Trust and funding it with a life insurance policy, you can ensure your dependent with a disability can still qualify for benefits like SSI.

Estate liquidity

Life insurance payouts typically come in the form of a large lump sum of money. This payout is fast and convenient, so if your estate needs to pay off any taxes, debts, and expenses, it can use the life insurance money instead of forcing asset sales. This ensures your heirs can safely inherit your assets as intended.

Wealth replacement

Life insurance can help replenish assets that are donated to charity or are used to settle obligations.

Fair distribution

Do you have multiple heirs? Life insurance is valuable for helping “equalize” inheritances among heirs when assets can’t be easily divided. For example, if you have real estate, it can be difficult divide it to multiple people who do not live together or share finances.

Family businesses can also benefit greatly from the fair distribution potential of life insurance.

Peace of mind

It’s comforting to know that your loved ones can at least meet their financial needs after you pass away. Life insurance doesn’t just provide a large sum of money, but it also gives that intangible peace of mind. Plus, it can alleviate a lot of stress for your loved ones who can receive financial breathing room during a difficult time.

How Life Insurance Fits Into an Estate Plan

Covering Final Expenses and Debts

Final expenses can be shockingly expensive, including funeral costs, debts, and outstanding loans. Anything that needs to be paid by your estate may disrupt your asset distribution if it forces asset sales or delays the probate process.

Life insurance can prevent your loved ones from needing to dip into savings or selling property in order to deal with final expenses and debts.

Providing Immediate Liquidity

Estate taxes and legal fees are often due before the heirs can receive their assets through probate. The life insurance payout is essentially immediate, unless there are suspicious circumstances regarding the policyholder’s death (e.g. homicide). Plus, the life insurance proceeds are tax-free funds, so they can be efficiently used to settle financial obligations.

Replacing Lost Income or Assets

If you pass away while still making money, that could be years or even decades of lost income. Without life insurance, that lost income is simply lost.

Life insurance provides a large sum to replace lost income, which can go a long way to support your dependents, especially if you’re the primary earner. Choose a life insurance death benefit amount that you can afford but is enough to replace lost income. Generally, it is recommended to opt for coverage for at least 5x to 10x your salary.

In addition, life insurance money can also help replace assets that are given to charity or business partners through your estate plan. Just be sure your life insurance is structured properly if you want it to fund business interests.

Funding a Trust or Inheritance Plan

Life insurance policies can set a trust as the beneficiary. Trusts give you more controlled, tax-efficient distributions to heirs, and have various asset protection benefits if you opt for an irrevocable trust.

Equalizing Inheritances

Inheritances can be near impossible to divide equally at times. For example, if one of your children inherits the family business, what do you do about your other heirs who are not interested in running the business? Life insurance proceeds can provide equivalent or near-equivalent value to other heirs by simply giving large sums of money. By equalizing inheritances, life insurance death benefits can prevent your heirs from feeling like the situation is unfair.

Types of Life Insurance Used in Estate Planning

Term Life Insurance

Term life insurance is the most common type of coverage because it offers simple, affordable coverage for a set period. You can choose the term, which affects the life insurance premium and coverage. At the end of the term, you may need to take a medical exam if you want to renew the policy.

Term life insurance is ideal for lost income replacement and paying short-term debts. The amounts are typically lower.

Platforms like Ethos offer quick, affordable term life insurance with no medical exam for many applicants. This means life insurance is fast, easy, and painless even if you have health concerns.

Whole Life Insurance

Whole life insurance is a type of permanent life insurance. The lifelong coverage comes with cash value growth and other benefits. You can withdraw from it or take loans against it. The interest rates depend on your policy.

Whole life insurance can serve as a wealth-building and liquidity tool, but it is NOT for everyone. There is a monthly premium that you cannot miss, or there may be fees and coverage lapses. The value is immense, but the price is also steep if you don’t understand how to take advantage of its benefits.

Universal Life Insurance

Universal life insurance is another type of permanent life insurance. It comes with flexible life insurance premiums and adjustable death benefits, so you get more control over your coverage. Being able to adjust the policy details enables you to protect your loved ones better even throughout changing financial and life situations.

Survivorship (Second-to-Die) Life Insurance

Second-to-die life insurance is a special, rare type of life insurance that insures two people. It pays out only once both people insured have passed away. It is most commonly chosen by couples who only want the death benefit given out to their children if both of them die. It may be more affordable than regular life insurance. It can cover estate taxes and ensure your heirs receive full estate value.

Using Life Insurance to Reduce Estate Taxes

Estate taxes are both federal and state, though the state estate thresholds are lower. If your estate size exceeds the threshold, you will have to pay estate tax on the excess portion. You can be taxed up to 40% federally, which is a huge problem for large estates (over ~$15 million, check the current federal estate tax exemption amount to be sure).

Life insurance can be an incredible solution in this case. Policies can be deftly structured to:

• Provide heirs with funds to pay estate taxes
• Replace wealth lost to taxes
• Transfer assets outside the taxable estate when held in specific trusts

Pro tip: Combine life insurance with tax-efficient tools like Irrevocable Life Insurance Trusts (ILITs). Let’s dive into the features, pros, and cons of ILITs.

What Is an Irrevocable Life Insurance Trust (ILIT)?

An Irrevocable Life Insurance Trust is a legal entity that owns your life insurance policy. It keeps proceeds out of your taxable estate and offers other asset protection benefits. However, it is irrevocable, which means you won’t be able to easily modify the trust’s conditions or assets.

How it works:

• You create and fund the ILIT
• The ILIT purchases and owns the policy
• Upon your death, the death benefit proceeds go directly to beneficiaries, bypassing estate taxes and probate court

Benefits of an ILIT

An ILIT can protect the life insurance proceeds from creditors and plaintiffs in case you are involved in a lawsuit. Essentially, any assets placed into the ILIT are no longer yours.

You also can controls how and when funds are distributed by detailing the terms of the trust. You choose a trustee and successor trustee who would manage the trust.

In addition, an ILIT can reduce your estate tax liability, allowing your estate to stay below the state or federal tax threshold.

Pro tip: LegalZoom is an affordable online platform that helps you create or update valid trust documents before consulting an estate attorney.

Integrating Life Insurance with Other Estate Planning Tools

With a Will

A will is the most basic form of estate planning. After buying life insurance, make sure that the beneficiaries listed align between documents. Otherwise the probate process could encounter delays and confusion. Typically the life insurance policy’s beneficiary designation overrides the will’s choice.

With a Trust

A trust (an ILIT in particular) lets you control the timing and conditions for your asset distributions. This is ideal for minors, special needs beneficiaries, and other complex estate goals.

With Power of Attorney

Power of attorney authorizes someone to have legal authority to manage or maintain your life insurance policy (or other matters) if you become incapacitated.

With Charitable Giving

Life insurance proceeds can be used to easily fund charitable trusts or foundations while preserving your family wealth. This is an excellent choice for those wishing to build up their legacy and support worthy causes.

Common Mistakes to Avoid

• Naming the wrong beneficiary or failing to update designations after major life events
• Having the estate (not a person or trust) listed as the beneficiary, which can hurt your taxes
• Overlooking state inheritance or estate tax implications
• Not coordinating with other estate documents, creating conflicts

When to Review or Update Your Life Insurance

After any major life event, you should review your life insurance details and estate plan. You may need to update them because of:

• New children
• Retirement
• Marriage or divorce
• New relationships
• Acquirement of significant assets
• Gaining or selling a business
• New tax laws or estate tax exemptions
• You moved to a new state or country

Regular reviews are also important. Check essential parts of your estate plan every 3 to 5 years so they are always up to date. If you have an attorney, they can remind you, but you can also set personal reminders using free apps.

Conclusion: Life Insurance Is the Foundation of a Thoughtful Legacy

Life is full of uncertainties. You can lock in lower life insurance premiums if you’re younger and healthier. Life insurance provides a lot more planning flexibility than you think if you get it earlier, and it lets you protect your loved ones even as you prepare the rest of your estate plan.

Act early to protect your loved ones. Choose a life insurance policy today through Ethos, a company that makes life insurance coverage convenient and affordable. If you haven’t begun an estate plan yet, check out LegalZoom for easy ways to start.