Incorporating Life Insurance into Your Estate Plan

Under a life insurance policy, the insurance company agrees to pay a specified amount of money (the death benefit) to designated beneficiaries upon the death of the insured person. The death benefit can be used to replace lost income, cover living expenses, pay off debts, fund education expenses, or provide for other financial needs of the beneficiaries.

The two main types of life insurance that many individuals decide between are term life insurance and permanent life insurance (whole life and universal life).

Term life insurance provides coverage for a specific period, typically ranging from 5 to 30 years. If the insured person dies during the term, the policy pays out a death benefit to the beneficiaries.

Benefits

With term life insurance, premiums remain fixed for the duration of the term, providing predictability and ease of budgeting. The flexibility of term life insurance makes it an attractive option for individuals who are looking for coverage for a specific period, such as paying off a mortgage or providing for children. These policies can be more straightforward compared to alternatives. Term insurance policies do not offer investment components or cash value accumulations, which may simplify the decision-making process for some individuals. Lastly, term life insurance helps mitigate the financial risk of premature death, ensuring that beneficiaries receive a death benefit if the insured passes away during the term.

Drawbacks

One of the significant drawbacks of term life insurance is its limited duration. If the insured outlives the term, the policyholder receives no benefit, and coverage must be renewed at (likely) higher premiums or replaced with a new policy, which can become more expensive as the insured ages or if their health has changed. Additionally, it does not accumulate cash value over time, and policyholders do not receive any return on premiums paid if they outlive the term. Lastly, this type of insurance provides pure death benefit protection -- but only if the insured does not outlive the policy. It is ideal for short to medium-term needs but may not be suitable for individuals who require lifelong coverage.

Whole life insurance and universal life insurance are two types of permanent life insurance policies. Whole life provides coverage for the entire life of the insured, as long as premiums are paid. It also includes a cash value component that may grow over time, potentially tax-deferred. Policyholders can access the cash value through withdrawals or loans. Whole life insurance offers lifelong coverage and can serve as an investment vehicle, but it does tend to have higher premiums compared to term life insurance.

Universal life is another type of permanent life insurance that offers flexibility in premiums and death benefits. Policyholders can adjust the premium payments and death benefits over time to suit their changing needs. Like whole life, universal life policies also include a cash value component that earns interest, but the interest rates are often tied to market performance. This option offers flexibility but requires careful monitoring to ensure the policy remains funded adequately.

Benefits

The lifelong coverage provided by permanent life insurance increases the likelihood that beneficiaries receive a death benefit whenever the insured passes away, regardless of age or health status. The cash value accumulation in permanent life insurance policies is tax-deferred, meaning that policy holders do not pay income tax on the gains as long as the policy remains in force. Additionally, policy loans are generally not taxable as long as the policy remains in force, which provides a source of funds for emergencies, retirement income, or other financial needs.

Lastly, permanent life insurance can assist with estate planning benefits. It can be used as an estate planning tool to provide liquidity for estate taxes, equalize inheritances among heirs, or transfer wealth to future generations. By keeping the death benefit outside of the insured's taxable estate, permanent life insurance may help minimize estate taxes, driving more wealth to the next generation.

Drawbacks

Permanent life insurance policies typically have higher premiums compared to term life insurance, especially in the early years of the policy. During the early years of the policy, a significant portion of the premium payments goes toward commissions, administrative fees, and other expenses, rather than cash value accumulation. As a result, it may take several years for the cash value to grow to a substantial amount, and policyholders may experience cash value erosion if they surrender the policy during this time.

Permanent life insurance policies can also be complex, difficult to understand, and may create uncertainty for individuals who are depending on the policies to meet very specific objectives. Overfunding a permanent life insurance policy to maximize cash value accumulation can result in a Modified Endowment Contract (MEC) status, which changes the tax treatment of withdrawals and loans. Understanding the various components of the policy requires careful consideration and guidance from a financial professional, and policyholders should be aware of the MEC rules and consult with a tax advisor to avoid unintended tax consequences.

For investors, life insurance can play a crucial role in estate planning in several ways:

• Income Replacement: Life insurance provides a tax-free lump sum payment to beneficiaries upon the insured's death. This can replace lost income, especially if the insured was the primary breadwinner. This may help loved ones feel financially secure in the event of the insured's passing.
• Estate Liquidity: Estate taxes, debts, and other expenses can often create liquidity problems for an estate and beneficiaries. Life insurance proceeds can be used to cover these costs, ensuring that heirs receive their intended inheritances without having to sell assets at unfavorable prices or under market duress.
• Equalizing Inheritances: If a business or significant assets are left to one heir, life insurance can provide a way to equalize inheritances among beneficiaries. For example, if one child inherits the family business, the other children can receive their share of the estate through life insurance proceeds.
• Estate Tax Mitigation: For high-net-worth individuals, estate taxes can significantly diminish the value of an estate passed on to heirs. Life insurance may be a tool that can protect the wealth you have built wile providing a tax-efficient means to transfer wealth.
• Charitable Giving: Life insurance can be used to make significant charitable contributions. By naming a charitable organization as a beneficiary, the insured can leave a lasting legacy while potentially receiving tax benefits.
• Business Succession Planning: In the case of a business owner's death, life insurance can provide the funds necessary for a smooth transition of ownership. This ensures the business can continue operations without financial strain or the need for a forced sale.
• Debt Settlement: Life insurance can be used to settle outstanding debts, mortgages, or other liabilities, relieving this burden from the estate or surviving family members.
• Providing for Dependents: Life insurance may provide support for dependents, such as minor children or disabled family members, after the insured's death.

One vehicle for incorporating life insurance into an estate plan is an Irrevocable Life Insurance Trust (ILIT). An ILIT is a type of trust that is specifically designed to own life insurance policies. It is designed with the intent to keep the proceeds for the policy outside the insured's estate for estate tax purposes.

An ILIT is typically created by the policyholder (the grantor) during their lifetime. The grantor transfers ownership of one or more life insurance policies to the trust. Once transferred, the policies are owned by the trust, not the grantor. The trust document specifies the terms and conditions under which the trust operates, including the designation of beneficiaries and the distribution of assets. Although the ILIT is irrevocable, meaning that the grantor cannot make changes to the trust once it's established, there is still some degree of control and flexibility built into the trust structure. The grantor can specify the terms of distribution, such as when and under what circumstances the beneficiaries receive trust assets. Also, the grantor can appoint a trustee to manage the trust and ensure that the assets are distributed according to the grantor's wishes. The trustee can be an individual, a corporate trustee (such as a bank or trust company), or a combination of both.

One of the primary purposes of an ILIT is to remove the life insurance proceeds from the insured's taxable estate. Since the trust, not the insured, owns the life insurance policies, the death benefit would not be included in the insured's estate for estate tax purposes. This can be especially advantageous for individuals with large estates that may be subject to estate taxes upon their death. By keeping the life insurance proceeds outside of their taxable estate, they can potentially reduce or eliminate estate taxes and maximize the amount of wealth passed on to their beneficiaries.

To fund the ILIT, the grantor typically makes annual gifts to the trust to cover the premiums on the life insurance policies. These gifts are often structured to take advantage of the annual gift tax exclusion, which allows individuals to gift a certain amount each year to each beneficiary without incurring gift taxes. The trust the uses these gifts to pay the premiums on the life insurance policies, ensuring that the policies remain in force and that the death benefit will be available to the trust beneficiaries.

Life insurance can serve various purposes, including income replacement, charitable gifting, and legacy planning, and an ILIT can be a powerful tool in estate planning for individuals who want to maximize the amount of wealth passed to their beneficiaries. However, setting up and managing an ILIT can be complex, so it's essential to work with experienced professionals, such as estate planning attorneys and financial advisors, to ensure that your estate plan is designed to meet your financial goals.

If you'd like to learn more about developing a financial plan that helps you meet your goals, you can send a message to one of our advisors here.