Using Life Insurance in Estate Planning

Written by True Tamplin, BSc, CEPF®

Reviewed by Subject Matter Experts

Updated on September 07, 2023

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Life Insurance in Estate Planning Overview

Using life insurance in estate planning is a strategic approach that ensures your loved ones' financial security after your demise.

This involves acquiring a life insurance policy and designating it in a way that aligns with your estate planning objectives.

The main purpose of this approach is to provide immediate financial aid to your family, cover estate taxes and related expenses, serve as income replacement, and facilitate fair distribution of assets.

The context of this strategy spans various demographics and financial situations, underscoring its relevance for individuals with dependents, substantial debt, or those looking to maximize their estate's value while minimizing potential tax implications.

It reiterates the role of life insurance as an essential tool in comprehensive estate planning.

Uses of Life Insurance in Estate Planning

Provides Immediate Funds

Upon the death of the insured, life insurance can provide immediate funds to the family or heirs. This financial support can be especially crucial during a difficult time when income might be disrupted.

Estate Taxes and Expenses

The proceeds from life insurance can be used to pay estate taxes and other related costs such as funeral expenses or debts. This prevents the need to sell off assets hastily and potentially under unfavorable market conditions.

Income Replacement

If the insured has dependents who rely on their income, life insurance can serve as a replacement for lost income, providing ongoing financial support.

Equitable Distribution of Assets

Life insurance can help ensure a fair distribution of assets among heirs, especially in situations where certain assets (like a family business) cannot be easily divided.

Estate Liquidity

If an estate consists largely of illiquid assets like real estate, life insurance can provide the necessary liquidity to cover estate taxes and other costs, avoiding the need for a fire sale of assets.

Reducing Estate Taxes

By setting up an Irrevocable Life Insurance Trust, life insurance proceeds can be excluded from the taxable estate, potentially reducing estate tax liability.

Use of Life Insurance in Estate Planning

Types of Life Insurance Policies for Estate Planning

Different types of life insurance policies can be used in estate planning, each offering distinct benefits.

Steps in Acquiring Life Insurance for Estate Planning

Calculating the Need for Life Insurance

Determining your financial obligations, your current debts, and the financial needs of your dependents. Once you have a clear understanding of these elements, you can estimate the amount of life insurance required to protect your estate and loved ones.

Choosing the Right Type of Life Insurance

This depends on various factors, including your age, health, financial status, and long-term goals. Term life, whole life, universal life, and variable life insurance are the most common types, each with distinct features and benefits.

Naming Beneficiaries

These are the individuals or entities that will receive the death benefits from your policy. This decision plays a crucial role in ensuring the wealth transfer process aligns with your wishes.

Steps in Acquiring Life Insurance for Estate Planning

Establishing an Irrevocable Life Insurance Trust (ILIT)

An ILIT is a strategic tool in estate planning that allows for increased control over your life insurance policies and their proceeds.

Benefits of an ILIT

Establishing an ILIT has several advantages. One primary benefit is the potential for estate tax reduction. By owning the life insurance policy, the ILIT removes it from your taxable estate, potentially reducing estate tax liability.

Secondly, an ILIT provides enhanced control over the insurance proceeds. The terms of the trust dictate the distribution of benefits, allowing you to guide when and how beneficiaries receive funds.

Thirdly, ILITs offer creditor protection. Since the ILIT is the legal owner of the policy, it can shield the policy's proceeds from your potential creditors.

Lastly, the ILIT can provide liquidity to your estate. This can be vital in scenarios where your estate primarily comprises illiquid assets like real estate or a family business, as the proceeds from the life insurance can cover estate taxes and other costs without the need to sell assets.

How to Set up an ILIT

Setting up an ILIT involves a few key steps.

1. Consult With an Estate Planning Attorney: Establishing an ILIT is a complex process that requires professional guidance.

2. Draft the Trust Document: This document outlines the terms of the trust, including trustee designation and beneficiary details.

3. Fund the Trust: You'll need to transfer ownership of your life insurance policy to the trust or have the trust purchase a policy.

4. Maintain Trust: Ensure premium payments are made regularly, and review the trust periodically to align with changes in estate planning goals or tax laws.

    Tax Implications of Life Insurance in Estate Planning

    Life Insurance, Death Benefits, and Taxes

    In most cases, the death benefits from a life insurance policy are not subject to income tax. However, if the death benefit is included in the insured's estate, it could be subject to estate tax.

    Estate Tax Implications

    If the insured person owns the policy at the time of death, the death benefit could be considered part of the estate and be subject to estate taxes. Establishing an ILIT can help avoid this situation.

    Common Mistakes in Using Life Insurance in Estate Planning

    Avoiding common pitfalls can help optimize the benefits of using life insurance in estate planning.

    Some common mistakes include failing to regularly review and update life insurance policies, making improper beneficiary designations, and not incorporating life insurance into a broader estate plan.

    The Bottom Line

    Life insurance emerges as a crucial element in estate planning due to its versatile functions. It serves to ensure immediate financial support for the family, assists in settling estate taxes, acts as an income replacement, and promotes equitable asset distribution.

    Selecting the right type of life insurance policy — whether term, whole, universal, or variable — depends on individual circumstances and long-term objectives.

    Creating an Irrevocable Life Insurance Trust can further enhance control over policies, provide creditor protection, and facilitate liquidity to the estate.

    It is essential, however, to avoid common missteps such as neglecting regular policy reviews and making unsuitable beneficiary designations.

    Through careful planning and execution, life insurance can be a powerful tool in safeguarding your loved one's financial future and fulfilling your estate planning goals.

    Using Life Insurance in Estate Planning FAQs

    About the Author

    True Tamplin, BSc, CEPF®

    True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.

    True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide, a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.

    To learn more about True, visit his personal website or view his author profiles on Amazon, Nasdaq and Forbes.

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