Many people think of life insurance as nothing more than a means to ensure that dependents are provided for. While that is obviously a key benefit of a good life insurance policy, there are other reasons to consider life insurance as an element in your estate plan. For example, the right policy can:
- Provide cash for expenses such as settlement of estate debts and costs of administration
- Provide short-term cash to support dependents while the decedents assets move through probate
- Provide a liquid asset from which to make smaller bequests, avoiding the need to liquidate assets such as real property
- Provide support for non-liquid assets, such as payment of property taxes on real estate that is part of the estate
There are two different categories of life insurance, and two different ways to pass the proceeds to beneficiaries. The right approach for you depends on a variety of factors, and is best determined in consultation with your financial advisor.
Term Life Insurance v. Permanent Life Insurance
While there are many different types of life insurance, they fall into two general categories: term life and permanent life insurance.
Term insurance is the simplest type, and typically the most affordable. The core feature of a term life insurance policy is a death benefit payable to a designated beneficiary upon the insured’s death. Many people favor this type of insurance because it is straightforward and the premiums are relatively low, particularly for younger insureds.
Permanent life insurance varies in its particulars, but the key distinction between term and permanent insurance is that in addition to a death benefit, permanent insurance policies accrue cash value that the policy owner can borrow against during the insured’s lifetime. Some common types of permanent insurance include whole life insurance and universal life insurance.
In short, term life insurance is typically less expensive and is carried solely for the purpose of securing a death benefit for the estate or for a chosen beneficiary. Permanent life insurance is more expensive, but is generally viewed as an investment rather than simply insurance, and offers other benefits to the policy owner. With the wide range of options, features, and premium pricing, choosing the right life insurance policy requires a careful assessment of your needs, priorities and budget.
Choosing the Named Beneficiary
The beneficiary of your life insurance policy may be your estate, a trust, or one or more specific individuals. There are benefits and drawbacks to each structure.
Estate as Life Insurance Beneficiary
When the estate is the beneficiary of a life insurance policy, the death benefit payout provides cash to the estate to deal with expenses such as the cost of administration, funeral expenses, professional services such as tax preparation, mortgage payments on property in the estate, and other short-term costs. The life insurance proceeds also infuse the estate with liquid assets, making it easier to maintain and distribute assets without being forced to sell off assets.
However, when insurance proceeds are paid into the estate, those proceeds become part of the estate for estate tax purposes. Careful planning is required to ensure that life insurance proceeds don’t increase the estate to the point that federal estate taxes are due, and the potential increase in state taxes must be considered. Another potential drawback to paying the death benefit into the estate is that proceeds are not available to meet the short-term needs of the deceased’s dependents.
Heirs as Life Insurance Beneficiaries
When an heir is direct beneficiary of the life insurance proceeds, the insurance proceeds are generally not included in the valuation of the estate, and thus not subject to estate tax. In addition, the death benefit is typically paid out to the beneficiary much sooner than distributions from the estate commence. This can be vital for dependents of the decedent who may not have adequate resources for the short-term. For example, if only one spouse is employed and the breadwinner spouse dies unexpectedly, the surviving spouse may have difficulty making mortgage payments and otherwise providing for herself and the children during the months it will take for the estate to settle.
Making good decisions about the type of life insurance policy that is best for your family and how that insurance policy will incorporate into your estate plan may require insights from both your financial advisor and your estate lawyer. If you don’t have life insurance, haven’t considered how your life insurance coordinates with your estate plan, or don’t have an estate plan at all, make sure your family is protected by getting the information you need.