Life insurance strategies for estate planning and why they matter
Estate planning needs differ for everyone depending on your estate, age, wealth, health, lifestyle and more. Regardless of your situation, life insurance estate planning strategies are a must, especially in the midst of the ongoing health pandemic.
When you start planning your estate, you might discover yours just requires a simple will to decide how assets will go to heirs. Complex financial situations call for more specific instructions. Either way, having a plan and making your wishes known is important.
Along with having a will, you should consider buying life insurance as a key part of your estate planning strategy. Doing so will help your beneficiaries maintain a good standard of living without you. It will also lessen the burden on your loved ones during an already sad and stressful time.
Upon your death, you can use the life insurance proceeds to pay for estate taxes as well as provide financial resources to your heirs. When used in conjunction with a will or living trust, insurance payouts will give your beneficiaries greater financial certainty and ease their legal burdens after you're gone.
Using life insurance benefits in estate planning
If you have a large amount of assets when you die, your beneficiaries may owe estate taxes when settling your estate. If this is the case, and your estate includes assets like a house, vacation property, jewelry, or other sentimental items, you surely don't want your heirs to be forced to sell these things just to pay the tax bill.
Instead, you can purchase life insurance to provide immediate cash. Your beneficiaries can use your life insurance payout, a lump sum of cash which will generally be tax-free, to cover these estate taxes—or any expenses they might have—without liquidating your estate.
Irrevocable life insurance trusts
In addition to using life insurance, you can also explore an irrevocable life insurance trust (ILIT) to transfer your wealth in a tax-smart way. With this strategy, you'll buy a life insurance policy for yourself and transfer it to the ILIT. Your heirs are made beneficiaries of the trust and the proceeds of the insurance policy are distributed to them after your death.
The policy's death benefit usually passes to the ILIT's beneficiaries tax-free. It is not included as part of your estate and not subject to federal estate taxes. Without an ILIT in place, the death benefit from your policy will be included in your gross estate. This amount could be subject to estate taxes.
ILITs must have a grantor, trustee(s), and beneficiary(ies). The grantor purchases the policy to fund the ILIT and gifts this policy to the ILIT permanently (hence, the name "irrevocable"). The grantor appoints a trustee to manage and distribute the funds to the ILIT's beneficiaries.
If you transfer an existing life insurance policy into the trust, you will encounter a three-year lookback period PDF opens in new window. This means that any payout issued within three years of transferring the policy into the trust will be counted in your estate.
You should consider whether the size of your estate will be big enough to incur federal estate taxes ($12.06 million in 2022 Opens in new window). If so, it's wise to organize this strategy with an estate planning professional sooner rather than later.