Why Is Life Insurance Important for Estate Planning?
The whole point of purchasing life insurance is to ensure that your loved ones have a layer of financial protection and resources after you’ve passed. Likewise, the entire point of estate planning in Huntsville, AL, is to ensure that there are several more layers of financial protection for your family while also safeguarding your assets.
Therefore, it should be no surprise that when the two are strategically combined, you’ll have an invaluable plan for providing your family with the financial support they need should you pass on early. The key is understanding how you can integrate them into a comprehensive plan.
There’s a lot to learn when it comes to making these two methods work together. This article is your guide to planning your estate around your life insurance plan, as we’ll cover everything you need to know and more.
Read on to learn more.
What Exactly Is Life Insurance?
Life insurance was initially created to help cover burial costs and provide for widows and orphaned children should one or both parents pass on unexpectedly. Today, it’s a much more flexible insurance product, although the concept behind it remains the same.
Essentially, life insurance is a contract between you and a life insurance company. In exchange for regular (monthly) payments, the insurance company provides a “death benefit” to your named beneficiaries in the event of your passing. Depending on the type of policy you purchase, the life insurance will cover natural deaths, accidental deaths, and in many instances, illness or injury while you’re still alive.
Life insurance policies come down to two types as well:
Term life
Permanent life
Term life will cover you for a fixed amount of time, while permanent life insurance will cover you for the rest of your natural life.
Generally speaking, term life insurance is cheaper compared to permanent life insurance. However, specific permanent life policies, such as whole life insurance, allow you to build cash value over time. They also don’t expire as long as you continue to pay your premiums. Additionally, suppose you can add a return of premium rider onto your term life insurance policy. In that case, you’ll be able to recuperate some of the money you paid into the procedure once the term expires.
What Exactly Does Life Insurance Cover?
As stated, the purpose of life insurance is to provide financial support for your beneficiaries (spouse, children, and other dependents) once you pass on. However, your actual death benefits depend on the policy you have, which means your life insurance policy will cover some or all of the following:
Natural death, includes dying from a heart attack, old age, or a disease. Of course, if you have a pre-existing condition when getting your policy, it may be excluded from your coverage.
Accidental death, which includes death by car crash, drowning, or even poisoning. The accidental death benefit may be purchased as a stand-alone policy or as a rider to an existing policy.
Suicide. Most life insurance policies will cover suicide. However, that’s only if it occurs after the policy’s waiting period — which is typical for the first two years of your coverage.
Homicide. Life insurance also usually covers homicide. However, the circumstances of that homicide can have an impact on the payout. For example, if the insured is murdered by a beneficiary, there won’t be a payout.
Illness and injury. Many policies offer coverage for illnesses and injuries while you’re still living. For example, a critical or chronic condition rider will cover life-threatening diseases, such as cancer, or conditions that can permanently inhibit your everyday activity. You can also purchase an accelerated death benefit rider to give your beneficiaries access to your death benefit if you’re diagnosed with a terminal condition.
It should also be noted that accidental death and dismemberment insurance will cover both accidental death and serious injuries should you survive. This can also be added as a rider to an existing policy or purchased on its own.
How Does Life Insurance Work?
The way life insurance works depends on whether you purchase term life insurance or permanent life insurance.
With term life insurance, you’ll get coverage for a certain time frame, such as 10, 20, or 30 years. Should you pass away during your chosen time frame, your policy will pay out your death benefits to the named beneficiaries in the amount stated on the policy. If you live past your policy’s expiration date, there won’t be a payout.
Term life insurance tends to be more popular since it offers large payouts at a lower cost. However, it is a temporary plan with some variations, including convertible policies, which allow you to convert them into permanent life policies (usually at a higher rate) for longer coverage.
With permanent life insurance, you’re essentially covered until the time of your death — as long as you keep up with your monthly premiums. Permanent life insurance also comes in several types, including whole life, universal life, and variable life, which vary in cost, coverage, and death benefits.
Permanent life insurance also builds a cash value as they age, as a portion of your premium payments are added to this value and earns interest over time. For example, whole-life policies increase your cash value at a fixed rate, while universal policies are variable and fluctuate to reflect the current market.
Moreover, you can use the cash value built up in your policy while you’re still living. This means you can make withdrawals, borrow from it, or use the interest payments to cover your monthly payments after retirement. You also have the option to surrender your policy, which means you would be trading in your death benefits for the policy’s current value (minus a few fees).
How Does Life Insurance Factor Into Estate Planning?
There are a few ways that life insurance can be incorporated into your estate planning. First and foremost, it’s important to view life insurance through the scope of your overall estate plan, meaning you should look at it as another means to provide your family with financial support for lost income, cover funeral costs, and help pay off any lingering debts.
In many instances, life insurance policies end up exempt from the federal taxes your estate will be subjected to after you’ve passed. Therefore, it’s not uncommon for death benefits to be used to help cover these taxes in the event that there aren’t enough assets left behind or during any delays in the distribution of your assets.
Let’s take a look at all the ways life insurance factors into your overall estate plan:
Final Expenses
As mentioned above, your loved ones may end up facing some expenses (expected or unexpected) after you’ve passed on — and they may or may not be financially prepared.
For example, the average cost of a funeral is upwards of $7,000, depending on your burial plan. Additionally, any debts you incur over the course of your life that aren’t settled before you pass will become the responsibility of your estate — and your family.
Life insurance funds can also be used to cover any inheritance taxes associated with your estate, including any imposed federal taxes.
Lastly, you have final income taxes to consider. This includes any back taxes required by the government and any taxes you owe during the year of your death.
Life insurance can help cover these expenses while providing additional funds for your beneficiaries to meet other obligations without having to tap into the financial resources that come from your estate — such as selling the family home, business, heirlooms, or other believed assets.
Estate Equalization
When you have multiple heirs to think about, dividing your assets up equally may not work the way you want.
Here’s a hypothetical example:
Let’s say you pass away and leave behind a vacation home worth about $600,000 to your three children, who are now adults. One child wants to keep the vacation home in the family, while the other two want to sell it and split the money equally. If the child who wants to keep the house can compensate the other two children with what their fair share would be, he or she would get to keep the house. But who has $400,000 lying around?
In such instances, the money that comes from your life insurance plan can be used to equalize the estate inheritance among your heirs. In this example, with life insurance, the one child could keep the vacation home while the other two would receive the proceeds of your policy.
Therefore, life insurance can bridge the gap in the unequal division of assets to prevent any rifts after you’re gone.
Business Buyout and Ownership
If you own a small business or co-own a business, your passing could pose some challenges for those responsible for the business in your place. The proceeds from your life insurance policy can remedy that situation.
Many businesses have plans established when it comes to handling the loss of a business member, and it’s usually referred to as a buy-sell agreement. This is a contract outlining how a departing owner’s share in a business should be sold or reassigned when the time comes.
The proceeds of your life insurance policy can act as the funds needed to honor this agreement, especially if it calls for one of your heirs to take on your share.
Avoiding Probate
Probate can be a long, drawn-out process as it involves settling your estate and distributing your assets. Even with a will and trusts, it can take up to nine months in the state of Alabama.
Your family could end up waiting in limbo for much-needed financial support.
On the other hand, your life insurance proceeds skip probate entirely and go straight to the named beneficiary on your policy. This also allows the payout to remain private since life insurance is separate from wills and trusts.
Special Purposes
One unique thing about life insurance policies is that they can be “directed” for a specific purpose or need. For example, divorce obligations such as spousal or child support, or continuing financial support for a loved one.
These types of directed purposes are most often established using a trust. By putting your life insurance policy into a trust, you’ll be ensuring that the proceeds are held on the behalf of your beneficiary under the supervision of an appointed trustee.
There are several types of trusts you can choose from, including a revocable trust, which is increasing in popularity. Your Huntsville attorney can walk you through your options to help you choose the right one.
Ready to Talk Life Insurance?
If you have a family or other loved ones that depend on you, purchasing a life insurance policy is essential. It will ensure that they’re taken care of should you pass unexpectedly, and is especially powerful when combined with your estate plan.
Want to learn more about how to incorporate your life insurance policy into your estate plan? Schedule a consultation with Sarah S. Shepard or one of our experienced Huntsville estate planning attorneys.