Life Insurance for Estate Planning

As a provider for your family, taking care of your loved ones is a priority. Using life insurance for estate planning can help ensure their financial well-being, no matter what happens.

Your life insurance policy's death benefit is a source of cash that beneficiaries can use for a variety of needs. That makes it a valuable planning tool for your family, especially if they rely on your earning ability. If you have considerable assets to pass along, life insurance may even offer tax savings and other potential advantages for your beneficiaries.

But is life insurance part of an estate? And if it is, how so? Explore some basics of what you need to know about life insurance and estate planning here. Learn to better navigate both as you seek to achieve your financial goals while supporting your loved ones.

Is Life Insurance Part of an Estate?

Deciding how to allocate assets after your death is something to carefully consider, even as a younger adult. That's especially true if you have dependents or own a business. Including life insurance in your estate plan helps ensure that those who depend financially on you are safeguarded.

While life insurance is often a key part of the estate planning process, the death benefit generally isn't part of your estate in the formal sense. That's because the proceeds typically go directly to the beneficiaries listed on your policy without going through probate and courts. As a result, your beneficiaries generally receive the funds quickly — often within a month of filing a claim.

However, there are cases where the death benefit from your policy does have to go through probate. This can happen, for example, if:

• You didn't name a beneficiary on your policy documents.
• The beneficiaries you listed on your policy are no longer living.
• You named the estate itself as the beneficiary of the policy.

Even when the insurer can pay the death benefit without going through probate, that amount is still subject to federal estate taxes as well as state inheritance taxes, if applicable. If you have a large amount of assets or a relatively complex financial situation, an estate planning attorney can help develop a strategy that will better protect your loved ones and limit the impact of taxes on their inheritance.

Benefits of Life Insurance for Estate Planning

If you have family members or employees who depend on your earning ability, helping ensure their financial security is an important responsibility. Using life insurance as part of your estate plan can offer several advantages.

Provide for Your Family's Needs

Life insurance provides a death benefit that's typically tax-free to your beneficiaries. That income helps your family members make up for the loss of income you provided. It may also allow them to pay down any outstanding debts or manage future expenses, such as higher education costs or medical needs.

While younger parents are among the most common buyers of life insurance, they're not the only ones who should consider a policy. Seniors can use life insurance, for example, to help their family members pay for final expenses or manage unpaid bills.

More Effectively Manage Estate Taxes

More affluent individuals have more complex estate planning needs, including the need to prepare for potential estate taxes. While the threshold is high for federal estate taxes — it applies to assets over $13.61 million in 2024 — the impact can be substantial.¹ The IRS can tax 40% your estate at a rate as high as 40%, depending on its size. In addition, several states impose their own tax on larger inheritances.

When it comes to the federal estate tax, beneficiaries typically have only nine months to pay the amount due.² Without adequate planning, that could force your loved ones to sell illiquid assets, such as real estate or artwork, at fire sale prices. Or, they may have to sell stocks or other securities when the market is experiencing a temporary downturn. By contrast, a life insurance policy can typically provide a relatively fast source of cash to cover those taxes, regardless of economic conditions at the time.

Help Ensure Business Continuity

If you own a business, the well-being of your company and your employees is always a major concern. A life insurance benefit that's payable to the business — sometimes called "key person" insurance — can help your staff continue operations after the death of an essential employee. Proceeds can help hire a replacement and pay bills that come due, in order to help maintain the business as a going concern.

While you're the insured on the key person policy, the business itself typically pays the premiums and receives the death benefit upon your death. If you stay with the company until retirement, companies will often have an agreement that transfers the policy to you as an employee benefit.

Leave a Legacy

Leaving a life insurance policy to one or more charities of your choice allows you to continue supporting the causes you're passionate about. Your gift can help the organization pursue its mission. You can list a charity as the sole beneficiary of the policy or as one of multiple beneficiaries, depending on your objectives.

You can't take a tax deduction on a policy you own, even if you list the charity as a beneficiary. However, if you transfer ownership of an existing policy to a nonprofit, you may qualify for a write-off in the year you make the gift. Often, the organization will require you to make future premium payments, though you can generally deduct those subsequent payments from your taxable income.

What Types of Life Insurance Are Suitable for Estate Planning?

Choosing the right type of life insurance policy helps ensure you address your specific estate planning objectives. Insurance products come in two main types: term life and permanent life. Both have potential advantages, depending on your needs.

Term Life Insurance

Term life insurance is the most basic and typically most affordable type of coverage. The policy is in effect for a certain period — generally 10 to 30 years. If you pass away during that term, your beneficiaries receive a death benefit from your policy.

That makes term insurance a sensible solution for families that only need protection while their children are still young. However, these policies may be less ideal for situations where you need life-long coverage.

Permanent Life Insurance

Unlike term insurance, permanent life insurance policies provide coverage that lasts for as long as you pay the required premiums. In addition to paying a death benefit to your beneficiaries, they allow you to build cash value over time. You can access that cash balance to manage your own financial needs later in life, such as an unexpected home repair or a child's wedding.

Permanent life insurance is a broad category that includes the following types of policies:

• Whole life. The premiums remain the same throughout your lifetime. The cash value in a whole life policy grows at a guaranteed fixed rate, regardless of market conditions.
• Universal life. With a universal life policy, you can adjust your premiums and death benefit as your needs change. When you reduce your premiums, however, you may need to reduce your cash value to keep your policy in force.
• Variable life. Rather than receiving a fixed rate of return, your contract value changes with the performance of investment subaccounts you select. Variable life policies offer the potential for larger gains over time but also have the possibility that you may lose contract value during a market downturn.
• Variable universal life. These policies provide a hybrid of sorts between variable and universal life insurance. As with variable insurance, your cash value return is pegged to the performance of your investment choices. However, you can adjust your premiums each year as your circumstances change.

Using a Trust to Manage Life Insurance

A trust is a legal agreement where you allow a third party — the trustee — to possess and manage certain assets for the benefit of your beneficiaries. Making a trust the owner of your life insurance policy can provide certain benefits for those with unique financial needs.

Irrevocable Life Insurance Trusts

If you're a high-net worth individual, taxes can potentially take a considerable bite out of your estate when you die. Making an irrevocable life insurance trust the owner and beneficiary of your life insurance policy can be an effective solution. Creating an irrevocable life insurance trust typically shields the policy's death benefit from estate taxes.

The proceeds from the policy also represent a liquid asset your beneficiaries can use to pay taxes or other debts. When you draft the trust documents, you choose who will receive the proceeds of the policy. You can also stipulate when and how that money will be disbursed.

There are certain disadvantages to setting up an irrevocable life insurance trust, including the cost of administering the trust. Most important, because the trust is irrevocable, you can't undo the transfer of your assets. That means you can't tap into your cash value for personal use, as the policy is exclusively for the benefit of your beneficiaries. However, those potential downsides may be well worth it if your assets will be subject to hefty estate taxes.

Special Needs Trusts

You may want to consider a special needs trust if you have a child or another loved one with mental or physical disabilities. If your child receives life insurance proceeds directly, the additional income can interfere with their eligibility for government programs, such as Medicaid and Supplemental Security Income.

When you make a special needs trust the beneficiary of the policy, however, it doesn't count as a personal asset. Therefore, it won't typically impact their ability to receive need-based government benefits. You can stipulate that you want the trust to pay for certain expenses not covered by government programs, such as personal caregiver costs, medical bills or education costs.

Considerations When Creating Your Estate Plan

Estate planning can be a complex undertaking, one where seemingly small details can make an enormous difference. Here are a few things to keep in mind to help ensure your intentions are realized after you pass:

• Create a team of experts to guide you. When your financial professional, tax professional and estate planning attorney are all involved, it generally leads to better outcomes for your beneficiaries.
• Make sure you specify any beneficiaries on your life insurance policy, and make changes as needed. In the majority of cases, the beneficiary listed in your policy documents will supersede any instructions in your will.
• Determine the type of policy and the amount of coverage that best fit your needs. For example, a term policy works well if your family only needs financial support for a certain number of years, but it might not make sense if you seek life-long protection.
• Consider how your loved ones will pay the estate taxes if you're leaving behind a large amount of assets. The death benefit from a life insurance policy is one way to provide them with a fast source of funds to help cover that liability.

Sources

1. Estate Tax. https://www.irs.gov/businesses/small-businesses-self-employed/estate-tax.
2. Filing estate and gift tax returns. https://www.irs.gov/businesses/small-businesses-self-employed/filing-estate-and-gift-tax-returns.