How to Use Life Insurance in Your Estate Plan

Life insurance can play a key role in your estate plan by simplifying the transfer of assets and addressing potential estate taxes. It provides a reliable source of financial support for your beneficiaries through untaxed death benefit proceeds. By aligning life insurance with your estate plan, you can create a financial safety net that protects your legacy and provides long-term financial security for your loved ones.

A financial advisor can help you choose a life insurance policy for your estate planning needs.

What Is Life Insurance and How Does it Work?

Life insurance is a financial agreement between an individual and an insurer, where the insurance company promises to pay a specified sum to designated beneficiaries upon the insured’s death. This arrangement helps reduce the financial impact on survivors of losing a provider.

There are two primary types of life insurance :

• Term life insurance is simple and covers the insured for a set period, like 10, 20, or 30 years. It is popular for its affordability and provides targeted financial protection during important years, such as while raising children or paying off a mortgage.
• Permanent life insurance, including whole life and universal life, offers lifelong coverage and includes a cash value component that grows over time. Policyholders can borrow against or withdraw from the cash value under certain conditions. However, in estate planning, it’s important to note that the cash value cannot be inherited when the policyholder dies.

Life insurance premiums depend on several factors, such as the type of insurance, coverage amount, and the insured’s age, health and lifestyle. To get the most from life insurance, it’s important to choose a policy that fits your long-term financial goals and family needs.

Role of Death Benefits in Estate Planning

The death benefit can offer immediate financial support to beneficiaries as a tax-free lump sum paid when the insured passes away. This allows you to bypass probate, and the money can help cover estate taxes and other costs without having to sell other assets.

Life insurance death benefits can also help maintain the integrity of the estate’s value by preventing forced sale of assets such as homes, businesses, or heirlooms that may have emotional and financial value. This can be especially important in estates where assets are illiquid and may not be easily converted to cash.

When a Life Insurance Death Benefit Is Taxable

Generally, life insurance death benefits are paid out tax-free to beneficiaries. However, certain scenarios can trigger a tax liability.

If the life insurance policy is owned by the insured at the time of their death, the death benefit may be included in the estate’s value. This can subject it to federal estate taxes if the total estate value exceeds the periodically adjusted IRS threshold.

Also, if a beneficiary receives the death benefit as a series of installments that earn interest, the interest portion is taxable as income. This does not affect the principal amount of the death benefit but can influence the total taxable income of the beneficiary each year they receive payments.

Lastly, any benefits transferred to a third party under what the IRS terms as a “transfer for value” – such as selling or assigning the policy to another person before death – might also render the benefits taxable.

Avoiding Taxes on Death Benefits

Careful planning can help minimize or avoid taxes on the death benefit of a life insurance policy.

One effective strategy is to establish an irrevocable life insurance trust (ILIT) . Having the trust instead of the insured person owning the policy means it won't be included in the estate for tax purposes. This setup not only keeps the death benefit out of the taxable estate but also allows proceeds to be distributed directly to beneficiaries, bypassing probate.

Beneficiary designation similarly plays an important role. For example, avoiding naming the estate as the beneficiary can prevent the death benefit from adding to the estate’s value, which could push it over the federal exemption limit for estate taxes.

Bottom Line

Life insurance can be a key part of estate plans. It provides financial support to beneficiaries and helps maintain the estate's value. Both term and permanent policies can be useful. When combined with tools like irrevocable trusts, careful beneficiary designations can help ensure that assets are distributed as intended and minimize tax obligations.

Life Insurance Tips for Retirement

• A financial advisor can help you integrate life insurance into a broader retirement plan. Finding a financial advisor doesn't have to be hard. SmartAsset's free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you're ready to find an advisor who can help you achieve your financial goals, get started now .
• If you want to know how much life insurance you may need, SmartAsset's life insurance calculator could help you find a personalized policy that meets your needs .

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