How does life insurance enter into the estate planning picture?
Once you’ve considered the two “P’s,” property and people, a third “P” must be considered: protection. Your property and the important people in your life need to be protected against a couple of nemeses, namely taxes (income tax, federal estate tax, etc.) and lifestyle damage. Let’s look at each and how life insurance prevents these enemies from gaining a foothold.
Taxes
After you’ve completed your estate planning and directed how you want your property and other assets to be distributed, there is one other entity that must be considered: the tax liability.
If your taxable estate exceeds a certain value, your heirs may need to pay federal estate tax or inheritance taxes at the federal and/or state level. There are three ways for them to pay estate taxes:
-
Pay cash: This is not possible for many families
-
Sell assets: Your home or some of your other assets may need to be sold to gain liquidity for tax purposes
-
Use life insurance: It can be used to pay any taxes due
In most cases, the least expensive of these three options is to use life insurance proceeds. And, if your estate is planned properly, your beneficiaries will receive the policy’s death benefit tax-free.
In some cases, depending on the value of your estate, it might make sense to create an irrevocable life insurance trust (ILIT). This creates an exemption that removes the insurance policy from being counted as an estate asset.
You will likely need to consult an expert on tax law for legal advice.
Lifestyle damage
This is the adversary that concerns most people doing estate planning. In some cases, when you add up the assets, you’ll see that the value of those assets won’t sustain the lifestyle of your survivors in the manner they’re used to. And, of course, you also need to consider final expenses like end-of-life health care and funeral costs.
If you’re still working when you do your estate planning, you’ll see that your biggest asset is your future earnings. For example, if you earn $100,000 per year and have 25 years left before you retire, those future earnings are worth $2.5 million, not taking into consideration any future increases in your income.
Having enough life insurance in place for the payout to replace that income will safeguard your family’s lifestyle. They will be able to continue to stay in the same home if they wish, pay for the children’s education, pay their medical expenses and enjoy life without financial stress. Once you’ve accomplished this, your estate planning will have been a success.
