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The Importance of Incorporating Life Insurance into Your Estate Plan

Learn the importance of integrating life and disability insurance into your estate plan, including insights on choosing between term, whole, and universal life insurance, and the protective benefits these policies provide for your family's financial future.
Picture of By: Shannon McNulty, Attorney, The Village Law Firm

By: Shannon McNulty, Attorney, The Village Law Firm

Shannon's work is sophisticated and reflects her deep knowledge of the laws governing estates, taxation and child guardianship issues. Shannon approaches each client with sensitivity and compassion, understanding that many of the decisions that they will have to make can be difficult.

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In New York City, where anything can happen, securing your family’s financial future is more than a precaution—it’s a necessity. Life insurance is often a pivotal component of a comprehensive estate plan. Integrating life insurance policies into estate planning can provide financial security for your heirs and ensure that your estate is distributed according to your wishes. When used effectively, life insurance can solve a range of estate planning challenges, from providing immediate cash flow to beneficiaries to helping cover estate tax liabilities.

Incorporating life insurance into your estate plan requires careful consideration of the type of policy that best suits your needs, whether term life insurance for temporary coverage or whole life insurance for permanent protection. It’s essential to understand the insurance company’s role in managing these policies and ensuring that they align with your overall estate objectives.

How Is Insurance Used in Estate Planning?

The most sophisticated trust is of little use if there’s nothing to put in it. Without the financial backing of instruments like life and disability insurance, even the best-laid legal frameworks might fall short.

Why Should You Have Both Life Insurance and an Estate Plan?

Incorporating life insurance into your estate plan can address many challenges. It can offer immediate liquidity to your estate, alleviating financial burdens on your heirs and preventing the need to prematurely sell off assets. For instance, if most of your assets are in the form of real estate, life insurance can provide funds so that properties don’t have to be sold in a down market to cover estate taxes or other expenses. Life insurance proceeds can also aid in equalizing inheritances among your heirs, providing specific amounts to each beneficiary without the need to divide physical assets or businesses.

What Is the Difference between Whole, Universal, and Term Life Insurance?

Life insurance is one of the most complex financial products you can buy. There are endless types of policies, some of which even experienced financial professionals find difficult to understand. To make things worse, life insurance agents are notorious for pushing the most expensive policies, which oft en aren’t the best choice.

The information below can help you understand the different types of life insurance, how to choose a policy that meets your needs, and how to figure out the amount of coverage you should buy.

Life insurance policies can be divided into two main categories: Term life insurance and permanent life insurance.

Term Life Insurance

Term insurance is the simplest and least expensive type of life insurance. A term policy provides coverage for a certain “term” of years for a fi xed annual premium. When that term is up, the premium often increases significantly to account for your age. For example, a 40-year-old man might pay $700 per year for a 20-year term policy with a death benefi t of $1 million. At the end of the 20 years, he might be able to renew it for $15,000 per year. If he has developed a health condition, the premiums may be much higher, or he may not be able to renew the policy at all. For an additional cost, some term policies allow the owner of the policy to automatically qualify for another policy when the term expires, regardless of the insured’s health.

Permanent Life Insurance

In comparison to a term policy, permanent insurance is generally more expensive. The typical permanent life insurance policy is called whole life insurance. To give you some idea of the difference in premiums, a $1 million whole life policy for a 40-year-old male might cost $6,000 per year, compared to $700 per year for a term policy. With a whole life policy, however, the premiums never increase, and you can maintain the insurance regardless of your health. 

Permanent life insurance is best thought of as a term policy plus an investment vehicle. When you are younger, the insurance company allocates a portion of the premium to term insurance and invests the remainder, which is used to build up a cash value and to offset the higher cost of insuring you as you get older.  In most cases, purchasing a term policy and investing the remainder in a diversified stock and bond portfolio will provide a higher return than purchasing a whole life policy and having the insurance company invest the money for you. Separating your investment from your insurance allows far greater flexibility to respond to changing plans or circumstances. If you invest money in stocks and bonds and decide to buy a vacation house instead of saving money for your heirs, there is no penalty to sell the investments. If, instead, you had invested the money in a whole life policy and then decided to use the funds from the policy for another purpose, you would pay a heavy financial penalty for cancelling the policy and withdrawing the funds. You may be able to borrow against the policy, but that, too, will cost you.

Universal Life Insurance

A universal life insurance policy is a type of permanent insurance that is a hybrid between a term policy and a whole life policy. A universal life policy allows greater flexibility in the investment portion of the insurance, with the potential to earn higher returns and reduce premiums in later years. However, like a whole life policy, it cannot be cancelled easily, and if the investment portion fails to perform as expected, premiums can skyrocket in later years.  As a result of poor predictions by insurance companies, universal life insurance policies have created significant problems in recent years, as older policyholders have been forced to pay unexpectedly high premiums just to keep the policy in place and avoid a heavy penalty.

When selecting life insurance for estate planning purposes, it’s important to consider the different types of policies available, and make an informed decision about which type is right for your family’s goals.

Choosing the Right Beneficiary for Your Life Insurance Policy

Designating the appropriate beneficiary is crucial in using life insurance for estate planning. The beneficiary should align with your overall estate plan, ensuring the death benefit supports your intended estate distribution. Reviewing and updating your beneficiary designations regularly is vital, especially after significant life events like marriage, divorce, or the birth of a child.

We advise most of our clients to name their Revocable Living Trust as the beneficiary on their life insurance policy. This allows the assets to be used or distributed in accordance with your overall estate plan.

The Role of Life Insurance Trusts in Estate Planning

Because life insurance is often promoted as a tax-free asset, it is a common misconception that it is not subject to estate tax. While life insurance proceeds are distributed free of income tax, they are not exempt from estate tax. In fact, life insurance can make up a large portion of your taxable estate, with half of the proceeds going to taxes.

The good news is that you can remove life insurance from your taxable estate by holding the policy through an irrevocable life insurance trust (ILIT). By placing a life insurance policy within a trust, you can exert greater control over how the death benefit is distributed among your beneficiaries. The trust owns the policy, removing it from your taxable estate and potentially reducing estate tax liabilities.

Setting up an ILIT requires careful planning and adherence to legal guidelines. The trustee you appoint will manage the trust and oversee the life insurance death benefit distribution according to your specified terms.

Estate Planning with Different Types of Life Insurance

Understanding the different types of life insurance is crucial in estate planning. As explained above, term life insurance offers coverage for a specified period and is often used for short-term estate planning needs, such as providing financial support to minor children. On the other hand, permanent life insurance policies, like whole life or universal life insurance, offer lifelong coverage and can build cash value over time, which can be an asset in your overall estate. A permanent policy can also be used for income-tax advantaged retirement planning, by borrowing against the policy as you get older. Note that you may not be able to borrow against a policy that is held by an Irrevocable Life Insurance Trust.

There are also life insurance policies that convert to long-term care policies in the event that you need that type of care in the future. This can provide both protection for your heirs and protection for yourself.

When considering life insurance in estate planning, it’s important to evaluate how the death benefit of a life insurance policy will impact your estate’s overall financial picture and the inheritance your heirs will receive.

How Life Insurance Can Help Pay Estate Taxes

One of the primary uses of life insurance in estate planning is to provide funds to pay estate taxes. This is especially relevant for larger estates that may face significant federal and New York state estate taxes. The death benefit from a life insurance policy can be used to cover these taxes, ensuring that your heirs do not have to liquidate other estate assets to meet tax obligations. If you are planning to use your life insurance policy to cover estate taxes, make sure that the policy is held in an Irrevocable Life Insurance Trust, so that it doesn’t add to your taxable estate.

Our estate planning professionals at The Village Law Firm can provide essential guidance to ensure that your life insurance coverage aligns with your anticipated tax liabilities.

The Role of Life Insurance in Providing for Heirs and Beneficiaries

Life insurance can offer substantial financial support to your heirs and beneficiaries upon your passing. Whether providing for a spouse, children, or other dependents, life insurance can ensure that your loved ones are cared for financially. This is particularly important in cases where other estate assets are not readily liquid or if you wish to leave a specific inheritance to certain beneficiaries.

When selecting life insurance for this purpose, consider the needs of your heirs, their ability to manage a large sum of money and how the death benefit will complement other aspects of your estate plan. Any decision about life insurance should include an estate planning attorney so that the policy can be incorporated into your overall estate plan with minimal taxes.

Key Takeaways:

  • Life Insurance as a Financial Tool: Understand the role of life insurance and how it fits into your estate plan.
  • Beneficiary Designations: Regularly review and update your beneficiary designations to align with your estate planning goals.
  • Life Insurance Trusts: Consider using irrevocable life insurance trusts to control the distribution of your life insurance proceeds. It’s best to put this type of trust in place before you purchase a life insurance policy.
  • Estate Tax Planning: Utilize life insurance to address potential estate tax liabilities, especially in larger estates.
  • Providing for Heirs: Choose the right life insurance policy to ensure that your heirs are financially supported according to your wishes.

In conclusion, life insurance plays a vital role in comprehensive estate planning. By carefully selecting the right type of policy, designating appropriate beneficiaries and considering the use of trusts, you can ensure that your estate plan effectively addresses your financial goals and provides for your loved ones after your passing. Book a call with The Village Law Firm to gain personalized insight on how to incorporate insurance into your estate plan.

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