Life insurance is a very useful component of a family’s financial plan because it serves a multitude of purposes. Life insurance is most commonly used to fund the future financial needs of a family if the main breadwinner dies early. This is known as income replacement. But life insurance also serves a critical role in the family’s estate plan. The cash payment from life insurance can be used to provide liquidity to a family when they need extra time to sell real estate holdings or a family-owned business. Life insurance can also be used to protect a family from a large estate tax bill.
Estate Planning and Life Insurance
Estate Taxes
Most families may not be subject to estate taxes due to the high exemptions provided by federal estate tax laws. However, many people may find themselves with an unexpected estate tax bill because their state estate tax exemptions may be much lower. Also, tax laws seem to change frequently so it still makes a lot of sense to plan ahead to make sure your estate has plenty of liquidity to take care of any needed expenses.
For affluent families, simply buying a life insurance policy to provide necessary funds to care for family needs and potential estate taxes may not completely solve the problem. Any life insurance owned by an individual is included in his or her estate. If a person’s estate is subject to estate taxes, then the life insurance benefit will actually increase the size of the estate and also increase the estate tax itself. With Federal estate tax rates in excess of 40% and state estate tax rates ranging from 10% – 20% it is not hard to see that over half of the value of a life insurance policy will be eaten up by estate taxes. The tax bill alone could be in the millions of dollars. That could potentially leave the family with insufficient funds to take care of the needs of the family, a small business, or debt repayment. It’s not hard to see that there is wisdom in trying to limit the size of an affluent person’s estate.
We highly recommend that each family educate themselves on their estate plan options so they can create a plan that meets their needs and protects their financial interests. In order for an estate plan to actually work as intended, it needs to be in place well before a person dies.
What Is An Estate?
You might be wondering what an “estate” is exactly. A person’s estate is the sum of everything they own that has value minus any debts owed. In essence, it is a person’s total net worth. An estate includes the value of both tangible assets (ex: real estate) as well an intangible property (ex: copyrights). The estate also includes the value of personal property such as cars, wedding rings, coins, baseball card collections, etc. And of course, it includes the value of any life insurance owned by that individual.
To calculate the “net” value of the estate we must subtract all debts owed to outside parties (ex: home mortgage) as well as to individuals (ex: family members).
What Is Probate?
When you die, all of your assets that do not have a stated beneficiary will pass through your state’s probate court. A judge will oversee the administration of your estate to make sure your assets are given to the appropriate people. If you have created a living will then the judge will follow the instructions in your living will as closely as possible.
There are several problems with allowing your assets to be overseen by a Probate court. First, involving courts, judges, and lawyers in your financial affairs is very expensive. Their fees are billed to your estate. This means that your heirs could get a lot less of your estate than you intend. The more assets and debts you have means that the court will take a long time to gather all of your assets, pay off your creditors, and distribute the remaining assets to your heirs. The longer it takes, the more expensive it gets.
Another problem with probate court is the fact that family members might file a lawsuit against your estate if they feel they are entitle to more money than you have provided for them. Lawsuits get expensive and create divisions within the family. Yes, families do fight over money.
Why You Need An Estate Plan
If you would like to minimize your potential estate taxes, avoid probate court, and prevent your family members from fighting over your money when you die then you need to establish an estate plan. Creating an estate plan will help you make sure that your assets pass to your heirs in the way you want them to without the need to be overseen by a Probate court.
Life Insurance For Estate Planning
In estate planning we need to think about the long-term needs of your family. Because there is no way to predict when you will pass away, you will need a life insurance policy that is meant to endure for many years – perhaps even decades. It’s critical to use the right kind of insurance policy that will meet the various needs of your family:
- Liquidity
- High death benefit
- Ability to modify policy when needs/laws change and
- Minimization of insurance costs
A term insurance policy does not meet the needs of an estate plan because it only accomplishes one of those objectives. The right policy to use in estate planning situations is a cash value policy such as a Whole Life policy or Universal Life policy. These policies have a sort of investment component built into the policy that enable them to become self-funding at some point. If all of the premiums are paid, the death benefit will continue to increase over a long period of time without the owner needing to continually make additional premium payments. It’s possible that a whole life or universal life policy to deliver more in growth to the family than what was initially paid into the policy. In these situations, the policy actually pays for itself. Term insurance definitely does not offer this benefit.
Whole life and Universal life policies also provide a degree of flexibility to the family. In some cases the benefits and features can be modified to fit the changes to the family’s needs or to better fit changes to estate planning laws.
Estate Planning
When you die there are three places where your money will go after debts are paid:
- Family, friends, and other people you want to give money to
- Charitable organizations
- Government, courts, and lawyers
If you only want your money to be given to the first two then you need to have a plan in place. The typical estate plan will provide you with a Living Trust, a Living Will (including a pour-over will), Medical Powers of Attorney, and General Power of Attorney (financial management).
A Living Trust is fairly straightforward and simple to understand. All assets that are legally owned by the Trust will not be subject to the state’s probate process. You will name a “Trustee” who will be responsible for distributing assets to people or institutions according to your instructions. You can even have a professional trust management company to serve as the trustee to make sure everything is done correctly. The Living Trust is revocable, or changeable. While you are living you may make any changes you want to the trust. You can switch trustees, you can add or remove people who will receive your money (and/or amounts), and you can add or remove assets into or out of the trust. But once you die the trust becomes irrevocable, or unchangeable. As you can see, while you are alive it is a very flexible planning tool.
The downside to the Living Trust is that it will not provide you with any ability whatsoever to protect your assets from potential creditors, including the IRS or your state revenue department. That is why affluent families also use other legal structures to segregate certain assets from their “estate” and reduce taxes and legal liabilities.
Irrevocable LifeInsurance Trust (ILIT)
The Irrevocable Life Insurance Trust is a separate legal entity from your normal estate. Any assets placed inside your ILIT are permanently segregated from your estate. That means that funds placed in this kind of trust cannot be withdrawn. The benefit to the ILIT is that it provides a safety net of sorts for funds that are out of the reach of creditor claims of various sorts and ensures that these funds will not be subject to estate taxes. The tax savings alone can be very significant.
Because transfers to the ILIT are permanent, most people do not make large transfers into the trust. For estate planning purposes, the transfers made will be just large enough to fund a life insurance policy that will pay a large death benefit upon the death of the insured person. That money can then be “loaned” to your estate to take care of various expenses, including estate taxes.
As with any good plan, the ILIT is only effective if it is set up well in advance of your death or legal claims from creditors. The best time to create your estate plan is now.
And again, the best type of life insurance policy to use in conjunction with your ILIT is a permanent policy such as Whole Life or Universal Life. For married couples, the policy would typically be a Second-To-Die policy that pays out upon the death of the surviving spouse since the estate taxes are not due until the second spouse passes away.
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The best time to implement a plan for your estate needs is today. Call us for a free consultation with a licensed estate planning professional who can discuss your unique situation and determine the best course of action.