Provide support and liquidity with life insurance
Life insurance can play an important role in your estate plan. It’s often necessary to support the deceased’s family or to provide liquidity. To achieve your estate planning goals, it’s critical to carefully consider not only the type and amount of coverage you need, but also who should own the life insurance policy.
Replace lost earning power
If you’re still working, your first step should be determining how much your family will need to replace your lost earning power. Don’t just consider what you earn; also look at your spouse’s future earning potential. If your spouse is currently employed, consider whether becoming a single parent might impede career advancement and earning power. If your spouse isn’t employed, consider whether he or she would need to start to work and what his or her earning potential will be.
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. First consider your current expenditures for housing, food, clothing, medical care, and other household and family expenses. Then look at any significant debts, such as a mortgage and student loans, and your children’s education.
How do you determine the amount of insurance you need? Start by calculating 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 the projected expenses. Life insurance can be used to cover any shortfall.
When you quantify the numbers to determine what cash flow your family will need, the result may be surprisingly high. Depending on your age, 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. Of course, your situation is unique, so get professional advice before purchasing life insurance.
Choose the best owner
If you own life insurance policies at your death, the proceeds will be included in your 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.
Determining who should own insurance on your life is a complex task because there are many possible owners. 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. Do you want to replace income? Provide liquidity? Or 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, don’t 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 the size of the estate and the estate tax laws in effect at the survivor’s death.
Your children. Ownership by your children works best when your primary goal is to pass wealth to them. On the plus side, proceeds aren’t 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, however. 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 isn’t 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 business under a split-dollar arrangement. But if you’re the controlling shareholder of the company and the proceeds are payable to a beneficiary other than the business, the proceeds could be included in your estate for estate tax purposes.
An ILIT. A properly structured irrevocable life insurance trust (ILIT) could save you estate taxes on any insurance proceeds. Thus, a $5 million life insurance policy owned by an ILIT instead of by you, individually, could reduce your estate taxes by as much as $2 million if the entire amount is subject to estate tax and the rate is still 40%.
So how does an ILIT work? The trust owns the policy and pays the premiums. When you die, the proceeds pass into the trust and aren’t included in your estate. The trust can be structured to provide benefits to your surviving spouse and/or other beneficiaries. (See the Case Study “In an ILIT we trust.”)
ILITs have some inherent disadvantages as well. One is that you lose some control over the insurance policy after the ILIT has been set up.
