Most people have a basic understanding of what life insurance is and why you should purchase it. Yet, financial advisors say this tool is often misunderstood.
According to Ricardo L. Nazario, Senior Vice President, Wealth Management, Morgan Stanley Smith Barney, Houston, life insurancecan play an important role in the estate planning process.
“Life insurance is a very flexible estate planning tool that serves a myriad of uses,” he explains. “I would recommend doing your homework in this area with a financial planner and tax advisor to ensure coverage choices make sense for you and your family. There are many options to choose from and several ways to go about setting up each policy’s structure.”
It is possible that the Internal Revenue Service (IRS) may view an insurance policy on your life as part of your taxable estate if you are the owner of the policy. This is possible even if the policy’s death benefits are designated to go to a beneficiary whom you name. This could present you and your beneficiary with unexpected estate tax liabilities.
“In structuring the life insurance policy, you may want to consider removing the life insurance proceeds from your estate by setting up a new life insurance policy, or transferring ownership of an existing life insurance policy to an irrevocable life insurance trust,” says Nazario.
Under this type of trust, you are not the owner of the policy, so the death proceeds are not considered as part of your estate, he adds.
“You would make annual gifts to the trust to cover the insurance premiums, but when you die, the beneficiaries you name will receive the proceeds income- and tax-free.”
Nazario again points out that there are rules to both policy structures that need to be taken into account as you consider this tool in your estate planning process.
“The primary goal of life insurance is to provide beneficiaries with proceeds promptly and income tax-free,” says Nazario. “These tools often represent a preferred source of funds to a forced sale of existing assets or borrowing.”
Here are some common uses of life insurance for your estate:
Settlement costs: Life insurance helps to ensure your family is not burdened by significant debt from taxes or estate settlement liabilities. Generally, estate taxes must be paid in cash within nine months of your death.
Medical and funeral costs: Medical and assisted living expenses are often passed on to the family when one dies. Funeral costs may also need to be paid. Life insurance is one way to provide funds to pay these debts.
Family income:Proceeds from life insurance can be used by your spouse, children, grandchildren or other family members who need continued support.
Family business or foundation: Funds from life insurance can also be used to fund the transfer or continue the management of your business, or be used to form a family foundation.
Survivorship Life Insurance
If you and your spouse are U.S. citizens, using your unlimited marital deduction, you can leave any amount of assets to your surviving spouse free of gift or estate tax. However, this only postpones estate taxes until the death of the surviving spouse.
“You may want to reduce the estate tax burden here is by purchasing survivorship life insurance or “second-to-die” insurance,” says Nazario. “This type of insurance covers two lives with proceeds payable only after the second death.”
According to Nazario, here are three advantages to this type of insurance:
1. The premium payments are generally lower than for two separate life insurance policies.
2. Medical underwriting standards may be eased on wither you or your spouse because proceeds are paid at the second death.
3. Coverage is usually based upon the exact age of the younger policy owner, which means there is a longer period of coverage for the surviving spouse.
Other insurance plans to consider
Disability Income Insurance If you are working and are responsible for some or all of your family’s financial security, you may want to consider purchasing disability income insurance. This replaces any lost income that occurs due to a long-term illness, and could help prevent bankruptcy or the dissolution of appreciable assets to pay for any unexpected medical expenses.
Long-term Care Insurance One way to protect your estate from potentially devastating losses and liquidation from a prolonged illness is to buy long-term care insurance. These plans will generally help you pay for long-term care, and may cover in-home care, as well as nursing home care.
“Providing liquidity is perhaps the most important role life insurance plays in the estate planning process,” says Nazario.
The information contained in this article is not a solicitation to purchase or sell investments.Any information presented is general in nature and not intended to provide individually tailored investment advice. The strategies and/or investments referenced may not be suitable for all investors as the appropriateness of a particular investment or strategy will depend on an investor’s individual circumstances and objectives.