Everything You Need To Know About Life Insurance For Estate Planning

Estate planning can be a complicated task for anyone. It usually requires a team of lawyers and other advisors, and very oftentimes consists of multiple conversations between family members. But often what is forgotten during these talks, is the role life insurance crosses has when it comes to estate planning. 

Perhaps you may be worried that family members may have to take on unpaid debts from your estate, and/or pay taxes when they inherit your assets. If so, life insurance can play a vital role creating instant liquidity when your loved ones may very well need it most. It’s important though to be sure you have the right life insurance policy in place to address your estate planning needs.

Let’s start with estate planning and how life insurance helps the process. 

What Is Estate Planning?

Estate planning is the process of putting together a plan so that all your property, savings, and valuables are distributed the way you want to the people you want. Without proper planning, the beneficiaries of your estate may end up having to deal with a very time consuming, and oftentimes financial burdensome process oftentimes involving lawyers and the legality of the estate. 

Most people assume that estate planning is only for the rich who have a lot to give away. However, this is false and really anyone that owns things of monetary value (house, art, cars, etc.,) should have an estate plan for when they pass. 

A good estate plan will likely include two professionals at a minimum – a lawyer and your life insurance agent. Your attorney can draw up the legal documents and your life insurance professional can arrange for a life insurance policy to provide the liquidity so that cash is on hand when your beneficiaries need it most.

A solid estate plan will do a number of great things like potentially save your beneficiaries from having to deal with the extensive probate process. Not only can the time involved in the process be overwhelming but you also have court fees and legal fees that will need to be paid that perhaps could have been avoided.

Understand that if you decide not to plan, the state you live in will have their own plans for the distribution of your estate. Often it does not align with what someone wants. Typically, what happens is your estate will be distributed by a court order. Even if you have a spouse or children, they may only receive a portion or fraction of your estate. 

Also, you will likely want to include a power of attorney and a health care power of attorney if and when you were to become incapacitated. This is so someone that you trust can step in and make financial and health care decisions on your behalf if you are no longer able to do so. This does not need to be the same person. You can designate a different person for each.

Estate Planning and Life Insurance

Knowing what happens to any of your unpaid debts, how different state laws affect your estate plan, and understanding the role life insurance can play within a comprehensive estate plan

Unpaid Debts

It is crucial to designate who your beneficiary will be for your assets. Make sure you list a beneficiary for your life insurance as well as any retirement accounts you may have. If the estate is the beneficiary of the life insurance policy then creditors will have the ability to access the life insurance policy and use the estate to pay off those debts. In this situation, family members end up bearing the cost. 

Naming a beneficiary on you life insurance policy will allow your policy to bypass the probate process

Probate is when the estate is distributed to whom it is supposed to but first any taxes and debts owed are paid. 

For certain assets such as a home there is no place to designate a beneficiary. Oftentimes it is advised to set up a living trust and move certain assets such as your home to into the trust to help avoid the probate process.

Different State Laws

Each state has different laws for estate planning and needs to be carefully reviewed by your lawyers and life insurance policy. There are many things to consider but the most common issue estate planning faces is whether you live in a community property state or you live in a common-law state. 

Here are some of the basic differences between the two.

Common-Law States:

In common law states any property that was bought after marriage is not automatically owned by both spouses. What this means is that any property that is bought by an individual is that individual’s property unless they choose to share it with their spouse. 

An easy way to interpret this is a car and the title is in that individual’s name. Most common-law states however will have certain laws in place to protect a surviving spouse from disinheriting any of the estates from their marital partner should they pass. 

Community Property States:

In community property states any property that is acquired in marriage is an equal split between the spouses regardless of who paid for what. Any property that was acquired before or given to one spouse in inheritance is considered to be separate property. While a spouse can still leave their halves or separate property to the other spouse, certain state laws have their own process of estate planning. 

Currently, there are nine different community property states. They are:

  • Arizona
  • Washington
  • Idaho
  • New Mexico
  • California
  • Wisconsin
  • Texas
  • Louisiana
  • Nevada

By understanding each state’s estate laws, you can plan accordingly and buy a life insurance policy that protects your estate from these state laws and protect your beneficiary. 

Two Options of Transfer

The estate tax exemption for 2021 is $11.7 million per person or $23.4 million per couple. If the value of your estate including the future proceeds of your life insurance policy will exceed that amount you may wish to transfer your life insurance policy.

You will essentially have two options when it comes to transferring your existing policy. You can either transfer it to another person or to an irrevocable life insurance trust.

Transferring Life Insurance Policy to a Person

When you transfer your life insurance policy to another adult it is important to know that you cannot change your mind and alter that policy again. Once that is done it is a permanent change. This is less of an issue when it is transferred to a family member. However, if you have a falling out regardless of who it is, that life insurance policy for you is gone.

If you are transferring your life insurance to an adult it must be done three years before passing away. Otherwise the life insurance will be deemed to be a part of your estate and will be subject to estate taxes.

Irrevocable Trusts

You can also transfer your existing life insurance policy to an Irrevocable Life Insurance Trust or ILIT. This can can help minimize the amount of the assets in your estate that would be subject to estate tax.

In addition, it can protect any younger beneficiaries that may not be of age/ responsible enough to handle any money yet. The restrictions may put in place an age limit to access that trust. Irrevocable essentially means that once the terms are set up the grantor can’t amend them. 

ILIT’s can also provide a sort of business and liability insurance perhaps when it comes to any legality aspects. If the grantor owns a business the family will be protected from legal issues when they pass under the coverage of an ILIT. 

Life Insurance Policies with Estate Panning In Mind

So, with all that information, we can talk about some of the more common policies when it comes to estate planning. We can focus on the death benefit since that is what matters with estate and life insurance policies. 

When thinking in terms of life insurance we want to align it with:

  1. Taking care of our beneficiaries 
  2. Liquidity to the estate
  3. Taking care of our spouses

With these in mind, these are the most common life insurance policies. 

Dividend-Paying Whole Life Insurance

This type of insurance offers a guaranteed death benefit and functions similar to a stock where not only will you see what you put in but also get paid dividends based on the insurance companies’ profitability and success.

These premiums are some of the most expensive ones when it comes to whole life insurance. When it comes to estate planning the benefits go beyond just the estate so while this insurance policy is incredibly reliable, it may not be worth the cost for some. 

Guaranteed Universal Life Insurance

This is a low-cost permanent death benefit insurance policy. While cash growth Is usually minimal because of the relatively low-cost premiums, it is a great option for those estate planning because of its stability and ability to change the terms if need be. 

This is essentially a no-frills insurance policy that has a guaranteed death benefit. 

Convertible Term Life Insurance Policy

Typically, term life policies are less talked about when it comes to estate planning. This is because the idea with term life is that the benefactor will outlive the policy and will expire. With most of these plans not offering a return of premium, this adds no cash value while also being incredibly inexpensive. 

Why this may be ideal for some is that the convertible term life offers the term life to be replaced with a permanent life insurance policy as factors such as age and health changes. 

Working With One Another

When we think in terms of estate planning, often we think in terms of a will and who will inherit it. But when we incorporate our life insurance policies, we protect our family and loved ones from inheriting a mess. While some people think that their estates don’t matter because they are not large enough to qualify for taxes on the federal level, estates still need to be distributed appropriately at the grantor’s wishes. 

When the estate does in fact play a large role in taxes, it is important to consider transferring the life insurance policy to either an adult beneficiary or in the name of a trust. When neither of these things is done, creditors may be able to take advantage of the estate by paying off debts at the expense of your beneficiaries. 

Worse, certain state laws may distribute your estate where your family or spouses only receive a fraction of the estate while the rest of it is distributed by the court itself. By planning ahead with your lawyers and life insurance company, you can avoid all these issues.