For many families, life insurance is a way to replace lost income in the event a parent or spouse dies unexpectedly. But it can also be a valuable estate-planning tool for those who want to leave significant wealth to their heirs.
"Inheriting a large sum is not without its challenges," says Austin Jarvis, director of trust, tax, and estate at the Schwab Center for Financial Research. "But with the right life insurance policy, you can ensure your heirs are able to address those challenges without having to break up the estate."
Life insurance—yes or no?
There are two main types of life insurance:
- Term life insurance, which provides coverage for a fixed period of time (typically between 10 and 30 years). This is best suited for those with finite insurance needs—say, to provide for minor children until they come of age. The limited coverage makes it relatively affordable, particularly for young, healthy individuals.
- Permanent life insurance, on the other hand, provides lifetime coverage, making it suitable for estate-planning purposes. However, such coverage can come at a steep cost—typically five to 15 times that of a term policy—so "you should generally purchase permanent life insurance only if your estate is large or complex enough to demand it," Austin says.
In particular, permanent life insurance is most beneficial to those who want or need to:
- Pay estate taxes: Estates worth more than $12.06 million ($24.12 million for married couples) in 2022 are subject to taxation of up to 40%. What's more, the tax bill is typically due within nine months of the estate owner's death, which can pose a burden on heirs who inherit estates with significant illiquid assets, such as art, real estate, or a business. "A life insurance payout can keep your heirs from having to rush to sell those assets, potentially at below-market valuations," Austin says. Even if your estate doesn't exceed the current exemption, future tax changes are inevitable. "Over the past five decades, there have been no fewer than 10 significant changes to federal estate tax laws, which creates a lot of uncertainty when it comes to estate planning," Austin adds.
- Eliminate inheritance inequities: It's not uncommon for an estate owner to have assets that are difficult to divvy up among their heirs. "Family businesses and real estate, in particular, can be tough to bequeath to multiple heirs—especially if they don't have a shared vision for that asset," Austin says. "With life insurance, you can leave bigger assets to the appropriate heirs and offset any inheritance inequities with a policy of similar value."
- Provide for a special-needs heir: "When you have an heir who may never be able to provide for themselves, creating a plan for their financial security is paramount," Austin says. But the cost of lifelong care can undercut other heirs' inheritances. "In such cases, life insurance can be a great way to provide specific financial support for an heir with special needs while leaving the rest of the estate intact," Austin says. Just be careful when leaving assets to a special-needs heir who receives government benefits, as such payouts have strict income limits (see "Special needs trust," below).
How to deploy it effectively
Taking out a large life insurance policy can also add to the value of your estate, potentially diminishing the benefit of purchasing the policy in the first place. However, if you name an irrevocable trust as the beneficiary of your policies, the proceeds generally can be excluded from your estate and therefore be exempt from federal estate taxes. In addition, it provides immediate liquidity for your heirs to cover any outstanding estate fees or necessary expenses.
Two popular types of irrevocable trusts are often funded by life insurance:
- Irrevocable life insurance trust (ILIT): In such arrangements, the grantor transfers ownership of an existing policy to the ILIT or pays the premiums on a policy purchased by the trust. Since the ILIT's ownership of the policy is irrevocable—meaning it cannot be changed—the proceeds would not be considered part of your estate.1 Once the trust receives the policy's proceeds, the trustee can use the funds to cover taxes and fees and/or manage payouts to heirs.
- Special needs trust (SNT): For dependents with disabilities, a direct inheritance of as little as $2,000 could reduce or eliminate their government benefits. Creating an irrevocable SNT can help avoid this pitfall by stipulating that it will cover only qualified education, equipment, insurance, and medical expenses not covered by federal or state benefits. "Because the trustee pays the heir's expenses directly, no money flows to the dependent, which should preserve her or his government benefits," Austin says.
If you're looking to incorporate life insurance into your estate plan, Austin advises consulting an estate attorney and a tax professional as soon as possible. "The younger and healthier you are, the cheaper your policy will be," Austin says. "Generally speaking, once you've decided that life insurance is right for you, the time to act is now."
1The proceeds generally are excluded from the insured's gross estate as long as the insured didn't hold any incidents of ownership (such as changing the beneficiary or borrowing against the policy) at the time of death or within the three-year period prior to death.
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
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