Life Insurance as an Estate Planning Tool

Estate planning is a key component to an individual’s long term life planning.  To ensure the best possible result, an estate plan should be coordinated with other forms of planning such as investment, retirement and tax planning.  In addition, most individuals will include life insurance planning as part of their overall life planning.  For estate planning purposes, life insurance can be a very important and versatile tool.

There are several types of life insurance to choose from.  Term life insurance provides financial protection for a period of years.  It is the most inexpensive form of life insurance and is a good fit for younger people.  However, the premiums increase as a person gets older and unlike other types of life insurance, there is no accumulated cash value to a policy.

Whole life insurance protects an individual for their entire life. In addition, a whole life policy will accumulate cash value over time.  The cash value can be borrowed against and either be repaid or deducted from the death benefit payable to the policy’s beneficiaries.  Whole life insurance is more expensive that term life insurance because it acts as a savings plan as well as a form of protection.  Other types of life insurance include universal life and variable universal life insurance.

The uses of life insurance for estate planning purposes are numerous.  They include:

1) Income Replacement-Regardless of the type of insurance you own, the key component to all insurance policies is the death benefit.  For younger people, having an available resource to replace a loved one’s income stream is the biggest reason to own life insurance.  When purchasing insurance, it is important to determine how large of a policy will be necessary to replace an income stream in the event of an untimely death.

2) Estate Liquidity-Life insurance proceeds can be used to pay funeral expenses, debts, taxes and other expenses incurred at the time of a loved one’s death.  This is especially key for individuals with largely illiquid assets such as real estate and securities.  Without life insurance proceeds, these assets would have to be sold to provide an estate with the necessary cash to pay for these expenses.

3) Business Buy-Sell Planning-Life insurance can provide a family member with the means to purchase an interest in a family business.  Conversely, insurance may also be used by a non-family business partner to purchase a deceased individual’s business interests at the time of their death.

4) Inheritance creation/equalization-Life insurance can be used to create additional wealth to be passed to an individual’s heirs.  It can also be used to equalize inheritances in situations where other estate assets will not be shared equally amongst the individual’s heirs.

5) Estate reduction through gifting-For individuals who have taxable estates, using the annual gift tax exclusion to pay for an insurance policy can decrease the size of their taxable estate.  However, if the individual or the estate owns the insurance policy, the proceeds of the policy will be included in their taxable estate.

As indicated in number 5, if a life insurance policy is owned individually or by an estate, it is a taxable asset for estate tax purposes.  As an alternative, life insurance can be purchased by a trust known as an irrevocable life insurance trust (“ILIT”).  Insurance owned by an ILIT is considered outside of a taxable estate and the proceeds of an ILIT owned life insurance policy pass free of estate tax.  You can also transfer existing policies into an ILIT.  However, if an individual dies within three years of transferring a policy, the proceeds of the policy will be included in their taxable estates.

ILITs can be very helpful in passing wealth estate tax-free, but they require proper care and administration.  Insurance premiums must be paid by the trust directly to the insurance carrier.  The creator of the trust (the settlor) has limited powers regarding the insurance and should not be a trustee or a beneficiary.  The trustee of the trust must also follow all the formalities required by the trust instrument to ensure that the trust assets remain outside the taxable estate.

As you can see, life insurance can provide significant benefits to an individual and his or her heirs.  To ensure that you maximize those benefits, it is best to consult with both an estate planning attorney and an insurance professional to collectively determine the best possible plan for your specific needs.

Please contact info@levyestatelaw.com for more information about estate planning with life insurance.

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