Life Insurance and Your Estate Plan: 3 Big Takeaways

Life Insurance & Estate Planning

There’s a not-so-simple connection between life insurance and your estate plan, and, *spoiler*, just claiming a life insurance beneficiary in your will doesn’t cut it. John runs us through the three main considerations when thinking about your life insurance.



Life Insurance and Your Estate Plan

Today, we’re talking about the estate planning implications of life insurance.

Now, as part of every estate plan, just about all of my clients have some form of life insurance, but there are a lot of questions and a lot of confusion about this. So, I’m not somebody who’s going to sell you life insurance, but I do want you to make sure that you know some of the things that I think about and what I want my clients thinking about when we’re considering an integrating life insurance into an estate plan.

So, here’s the top three things you need to know about life insurance.

Life Insurance is Non-Probate Property

First, know that life insurance comes under a category of property that’s generally called non-probate assets. So, when we think about assets as part of estate planning, they’re two big groups of property. We want to think about number one: our probate property.

These are things that are going to be governed by the last will. So think about your car, probably your house, your socks, the stuff in your house. That’s going to follow what the will says. Meaning, it’s going to go through probate and it’s going to be subjected to paying any final debts. Then, whatever’s left gets paid out to the beneficiaries.

Now, non-probate assets includes life insurance, but it also includes things that have any sort of contract that tells the custodian of that account, so the life insurance carrier in this case, where the money goes when you die.

Basically, you’ve set up a contract with that company. And when you pass, they’re agreeing to pay it somewhere. So, for life insurance, your contract with them says that when you die, the beneficiary will get that benefit. It doesn’t matter what your will says. It doesn’t matter who the executor is. It’s going to go to the beneficiary name there.

Likewise 401ks, IRAs, 403B accounts, annuities, any bank account that has either a transfer on death or a pay on death, or even a joint tendency with right of survivorship, are non-probate assets. And, when it’s a non-probate asset, it’s going to go where the account says it goes, and it’s going to skip the terms of the will.

So it’s important to remember when you change your will, if you have a revocable trust agreement instead, life insurance isn’t necessarily going to follow those changes. It’s going to do what its beneficiary designation says. So, safety tip on that is make sure you know who the designated beneficiaries are because it’s not going to follow your will.

Understand the Different Types of Insurance

Item number two: know what type of insurance you’re getting and know why you’re getting it. The two broad types of insurance are term insurance and permanent insurance.

Term Insurance

This is there for people who are planning for an unexpected death in the next term of years. So, this tends to be cheaper insurance. It’s insuring your life for the next five, 10, 20, or 30 years, and you’re saying, “Look, if I die in the next term of years, then I want you to pay out this amount to whoever I’ve designated after that period of time is over. My death may not be unexpected. We’re not taking that chance.” So when you buy term insurance, you’re really saying my death during these next term of years is going to be unexpected. It’s going to put some hardship on the ones that leave behind. Therefore, I need to be able to replicate the income I have and, possibly, take some worries off the family in terms of paying off the house, maybe paying for college for loved ones. That’s what the term insurance is for.

Permanent Insurance

The other type of insurance to know about is permanent insurance. There are various different flavors of this universal whole life are the two big types, but permanent insurance insures you from now until the time you die. And this is more of an investment than insuring your unexpected death. This assumes it knows that you’re going to pass and it’s assuming that you’re going to pay from now until the time you die one way or another, and you’ll build up some cash value in that policy. But, it’s assuming it’s going to pay out that in contrast to that term policy. You’re just saying, “If I don’t die within these next few years, the money is just gone to the insurance carrier. And if I don’t die within that time, there is no benefit, with permanent insurance.”

It’s saying we know at some point you’re going to die. The insurance company is responsible for making a payout on my debt. So, again, the thing to know here is to make sure you’re getting the right type of insurance. If you’re young and really just insuring against an unexpected death, the term insurance is probably going to be the right answer for you. If you’re looking to actually make more of an investment and have a bigger return, no matter when you die, permanent insurance is probably where you’re looking.

Tax Implications of Life Insurance

Finally, the last thing to think about is the taxes that come along with this insurance. So, there are two different tax systems. We want to think about one income tax, which we’re all used. Every year, we file our 1040 report and pay tax on our income, deductions, losses, and credits. Then, the other system is the wealth transfer tax system, made up of the estate tax, the gift tax, and the generation skipping transfer tax. Now, life insurance has some magical properties. If we are talking only about income tax, the receipt of life insurance is exempted from income tax.

The difference, though, is that it’s still subject to estate tax. So, when we think about estate tax, the very short, very incomplete calculation for a estate tax is total all the property when you die that you own, and, if it is over the unified credit amount, then the IRS is going to be expecting a check of roughly 40% of the overage. Now, for people who know how to run this calculation, yes, I know I skipped over a lot of steps in that, and it is not a good way of thinking about it, but that’s a good shorthand. So, I don’t want to see that in the comments.

When we’re totaling up the assets that you own when you die, though, life insurance death benefits are included in that calculation. So right now the exemption amount is $11.7 million per person. If you are a single person and you own a $5 million stock portfolio and a $10 million death benefit life insurance policy, and you die, then guess what? 10 plus 5 equals 15.

You’re way over the limit, and you’re going to be sending, or rather your estate is going to be sending a check to the IRS. Now, the problems that you’re going to come up with are that life insurance may have gone to somebody who doesn’t want to write a check back to the executor or the IRS, but the executor is still going to be responsible for paying that tax.

So what do you want to remember? Life insurance is exempt from payment of income tax. The receipt of that is going to not be subject to income tax for the recipient, but it is going to be subject to estate tax. And we need to think about this when we’re calculating your potential exposure for estate tax.

In Summary

Life insurance can be a great tool to provide liquidity for families. There are things we want to think about. First, the beneficiary designations are important. What those beneficiary designations say will trump whatever is in the will, so you want to make sure that you’re checking that.

Number two: know the type of life insurance you’re getting and why you’re getting it. Term insurance is there to insure against an unexpected death over the next few years, whatever the term of that policy is. Permanent insurance, whether it’s whole universal or some other form of permanent insurance, is more of an investment and should be treated as such. It’s not there to insure against unexpected death. It’s there as a different type of investment, knowing that at some point you will, in fact pass.

Finally, know the tax consequences of this. Yes, life insurance is received free of income tax, but it is still potentially subject to estate tax, and you need to factor both of those tax planning options into your own personal plan.

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