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- Estate Planning Basics
- Fundamental questions
- Will or living trust?
- Other facts about estate settlement
- Determining potential estate taxes
- Estate Tax Saving Strategies
- The marital deduction
- Life Insurance
- Annual gifting
- Charitable contributions
- Strategies for family-owned businesses
- Special strategies for special situations
- Community property issues
- Implementing and Updating Your Plan
- Where do you go from here?
- Estate planning worksheet
- Planning Levels Fee Schedule
Life insurance can play an important role in your estate plan. It is often necessary to support your family after your death or to provide liquidity. Not only do you need to determine the type and amount of coverage you need, but also who should own insurance on your life to best meet your estate planning goals.
Support your family
Your first goal should be maintaining your heirs’ lifestyles in the event of your death. Carefully analyze how much from insurance proceeds they’ll need to replace your lost earning power. The first question is whether your spouse is employed. If your spouse is, consider whether becoming a single parent will impede career advancement and earning power. If your spouse isn’t employed, consider whether he or she will start to work and what his or her earning potential will be.
- Planning Tip
- By The Numbers
When you quantify the numbers to determine what cash flow your family will need, the result may be surprisingly high.
Next, look at what funds may be available to your family in addition to your spouse’s earnings and any savings. Then estimate what your family’s living expenses will be. Consider your current expenditures for housing, food, clothing, medical care, and other household and family expenses; any significant debts, such as a mortgage and student loans; and your children’s education, which can be difficult to estimate.
How do you determine the amount of insurance you need? First calculate how much annual cash flow your current investments, retirement plans and any other resources will provide. Use conservative earnings, inflation and tax rates. Compare the amount of cash flow generated with the amount needed to cover your projected expenses. Life insurance must cover any shortfall. When you quantify the numbers to determine what cash flow your family will need, the result may be surprisingly high. Remember that you may be trying to replace 25 or more years of earnings.
Avoid liquidity problems
Insurance can be the best solution for liquidity problems. Estates are often cash poor, and your estate may be composed primarily of illiquid assets such as closely held business interests, real estate or collectibles. If your heirs need cash to pay estate taxes or for their own support, these assets can be hard to sell. For that matter, you may not want these assets sold.
Even if your estate is of substantial value, you may want to purchase insurance simply to avoid the unnecessary sale of assets to pay expenses or taxes. Sometimes second-to-die insurance makes the most sense. (See Planning tip 5.) Of course, your situation is unique, so please get professional advice before purchasing life insurance.
Choose the best owner
If you own life insurance policies at your death and you die while the estate tax is in effect, the proceeds will be included in your taxable estate. Ownership is usually determined by several factors, including who has the right to name the beneficiaries of the proceeds. The way around this problem? Don’t own the policies when you die. But don’t automatically rule out your ownership either.
- Planning Tip 5
- Consider Second-To-Die Life Insurance
Second-to-die life insurance can be a useful tool for providing liquidity to pay estate taxes. This type of policy pays off when the surviving spouse dies. Because a properly structured estate plan can defer all estate taxes on the first spouse’s death, some families find they don’t need any life insurance then. But significant estate taxes may be due on the second spouse’s death, and a second-to-die policy can be the perfect vehicle for offsetting the taxes. It also has other advantages over insurance on a single life. First, premiums are lower. Second, uninsurable parties can be covered. But a second-to-die policy might not fit in your current irrevocable life insurance trust (ILIT), which is probably designed for a single life policy. Make sure the proceeds are not taxed in either your estate or your spouse’s by setting up a new ILIT as policy owner and beneficiary.
Determining who should own insurance on your life is a complex task because there are many possible owners, including you or your spouse, your children, your business, and an irrevocable life insurance trust (ILIT). Generally, to reap maximum tax benefits you must sacrifice some control and flexibility as well as some ease and cost of administration.
To choose the best owner, consider why you want the insurance, such as to replace income, to provide liquidity or to transfer wealth to your heirs. You must also determine the importance to you of tax implications, control, flexibility, and ease and cost of administration. Let’s take a closer look at each type of owner:
You or your spouse.
Ownership by you or your spouse generally works best when your combined assets, including insurance, do not place either of your estates into a taxable situation. There are several nontax benefits to your ownership, primarily relating to flexibility and control. The biggest drawback to ownership by you or your spouse is that on the death of the surviving spouse (assuming the proceeds were initially paid to the spouse), the insurance proceeds could be subject to federal estate taxes, depending on when the surviving spouse dies.
- Case Study II
- In An ILIT We Trust
Walter was the sole income provider for his family. While working on his estate plan, he and his advisor determined he needed to purchase life insurance to provide for his family if something happened to him. After calculating the size of the policy his family would need, Walter had to determine who should own it.
Because his children were still relatively young, Walter ruled them out as owners. He was concerned that if his wife were the owner and something happened to her, his children would lose too much to estate taxes. So Walter decided to establish an ILIT to hold the policy. Despite the loss of control over the policy, Walter felt the ILIT offered the best protection for his family, even if the estate tax was no longer an issue.
Your children. Ownership by your children works best when your primary goal is to pass wealth to them. On the plus side, proceeds are not subject to estate tax on your or your spouse’s death, and your children receive all of the proceeds tax free. There also are disadvantages. The policy proceeds are paid to your children outright. This may not be in accordance with your general estate plan objectives and may be especially problematic if a child is not financially responsible or has creditor problems.
Your business. Company ownership or sponsorship of insurance on your life can work well when you have cash flow concerns related to paying premiums. Company sponsorship can allow premiums to be paid in part or in whole by the company under a split-dollar arrangement. But if you are the controlling shareholder of the company and the proceeds are payable to a beneficiary other than the company, the proceeds could be included in your estate for estate tax purposes.
An ILIT. A properly structured ILIT could save you estate taxes on any insurance proceeds. Thus, a $1 million life insurance policy owned by an ILIT instead of by you, individually, could reduce your estate taxes by as much as $460,000 in 2006 (if you are in the highest estate tax bracket). How does this work? The trust owns the policies and pays the premiums. When you die, the proceeds pass into the trust and are not included in your estate. The trust can be structured to provide benefits to your surviving spouse and/or other beneficiaries. (See Case study II.) ILITs have some inherent disadvantages as well. One is that you lose control over the insurance policy after the ILIT has been set up.