There are several reasons to put an estate together. One of the main reasons is for those with grown children that want to ensure that their assets are divided and distributed equally. Adding a life insurance policy to an estate plan can help anyone from all walks of life, rich or poor, young or old.
Estate Planning 101
One common misconception in purchasing a life insurance policy is to name your estate as the beneficiary. This is not a wise decision. If you list your estate as the beneficiary, then the proceeds of your life insurance policy will first have to go through probate. The probate process can take months and even years to finish. Courts place estates through probate to ensure that the will left by the deceased is valid. While your estate is in probate your heirs will not be able to access any of the money paid out by your life insurance policy. This could be a problem, especially if the family was counting on using some of those funds to pay for your funeral expenses and immediate debt.
Furthermore, if the proceeds to your life insurance policy are added to your estate, that would only increase the value of your total estate. This could make your estate taxable. It all boils down to this one question, do you love your children or the government more? Depending on your estate, your heirs could be taxed over 40%. Life insurance replenishes your estate allowing you to pass on what you’ve worked hard to accumulate.
How Life Insurance Can Help with Planning your Estate
There are a couple of ways in which buying a life insurance policy can help with estate planning. First, a life insurance policy will help reduce or eliminate gift and estate taxes. For example, if you have a large estate and own multiple properties you might decide to bequest a summer home in the Hamptons to your son. Whether the bequest is property or other non-liquid items such as artwork or jewelry, the recipient is required to pay a gift or estate tax on the item. By taking out a life insurance policy, the funds can be used to offset those taxes. That would make your gift to your son truly a gift since he could own it outright, without the worry of having to pay an unexpected sum for the inheritance. The funds could also cover the various administrative costs associated with estates.
A second use for life insurance in estate planning is for junior generations to protect against having inheritances, such as residences, from being dragged back into an estate after it has already been passed down via a Qualified Personal Residence Trust (QPRT). QPRT’s are put together by a member of a family’s senior generation. The senior transfers a residence to the next generation. If the senior outlives the specified term of the QPRT then the residence eventually passes to the junior generation without any additional gift tax.
However, if the grantor dies before the specified term, the residence is subject to being brought back into the estate. So, having the life insurance policy helps guard against that by enabling the junior generation to buy the residence outright should the grantor unexpectedly pass away.
There are many more ways in which life insurance can be used to solve issues associated with estate and gift taxes. It is best to consult a professional to help you determine which planning techniques are appropriate for your situation.
For many years there were generally only 2 options for the type of life insurance: whole life and term life. There’s variable life, which we agree with financial gurus Dave Ramsey and Suze Orman, this is a total waste of money and an advisor will quickly suggest one, because the commissions are better for them. Therefore, work with someone who is more concerned with what’s better for you. If you’re married, a joint life and survivor-ship policy would be ideal, it can cover you and your spouse for both of your whole life –without the whole life price tag.
Bestselling author & CPA Stephen L. Nelson shares some tips on the different kinds of life insurance to buy:
Term life insurance is simple, straightforward life insurance. You pay an annual premium, and if you die, a lump sum is paid to your beneficiaries. Term life insurance gets its name because you buy the insurance for a specific term, such as 5, 10, or 15 years (and sometimes longer). At the end of the term, you can renew your policy or get a different one. The big benefits of term insurance are that it’s cheap and it’s simple.
The other flavor of life insurance is trickier, it’s called permanent insurance. Permanent insurance builds cash or “equity,” in the policy. Many people are attracted to cash-value insurance, because it supposedly lets them keep some of the premiums they pay over the years. After all, the reasoning goes, you pay for life insurance for 20, 30, or 40 years, so you might as well get some of the money back. With cash-value insurance, some of the premium money is kept in an account that is yours to keep or borrow against.
This sounds great. The only problem is that cash-value insurance usually isn’t a very good investment, even if you hold the policy for years and years. And it’s a terrible investment if you keep the policy for only a year or two. What’s more, to really analyze a cash-value insurance policy, you need to perform a very sophisticated financial analysis. And this is, in fact, the major problem with cash-value life insurance.
While perhaps a handful of good cash-value insurance policies are available, many— perhaps most—are terrible investments. And to tell the good from the bad, you need a computer and the financial skills to perform something called discounted cash-flow analysis. If you do think you need cash-value insurance, it probably makes sense to have a financial planner perform this analysis for you. Obviously, this financial planner should be a different person from the insurance agent selling you the policy.
What’s the bottom line? Cash-value insurance is much too complex a financial product for most people to deal with. Note, too, that any investment option that’s tax-deductible—such as a 401(k), a 401(b), a deductible IRA, a SEP/IRA, or a Keogh plan—is always a better investment than the investment portion of a cash-value policy. For these two reasons, I strongly encourage you to simplify your financial affairs and increase your net worth by sticking with tax-deductible investments.
If you do decide to follow my advice and choose a term life insurance policy, be sure that your policy is non-cancel-able and renewable. You want a policy that cannot be canceled under any circumstances, including poor health. (You have no way of knowing what your health will be like ten years from now.) And you want to be able to renew the policy even if your health deteriorates. (You don’t want to go through a medical review each time a term is up and you need to renew.)
Different companies offer different options, but which you need and how much you need are matters for heated debate. Those who sell one and make most of their commissions from it will vehemently try to convince you that the other is not a good investment. Please refer to our article about the pros and cons of every type of life insurance policy.
Almost everyone needs life insurance of one variety or the other. The type of insurance and the amount to purchase depend entirely upon you, your family your goals, and your needs. In any case, make sure the company you purchase insurance from is reputable and financially solvent. Don’t be convinced by a fast-talking sales person without doing your homework first.
Remember, we are life insurance experts, not tax advisors or attorneys. We are happy to work with your estate attorney or CPA to ensure your life insurance is tailored to your estate planning needs.