How To Use Life Insurance To Help With Estate Planning

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Estate planning involves making plans while you are still alive so your assets (and liabilities) are transferred in the most legally and tax-efficient way possible when you die. It can also include making plans for your medical treatment if you become incapacitated.

No one person is solely responsible for a person’s estate plan. Professionals often collaborate during estate planning to protect your assets, ensure a smooth transition if you own a business and streamline the probate process (which proves a will is valid).

“What one needs for estate planning depends on personal circumstances like state of residence and the probate rules in that state, assets (that usually go up with age) and specific family circumstances (for example, special needs children),” said Inga Timmerman, an assistant professor of finance at the University of North Florida and a Certified Financial Planner (CFP®).

Estate planning is not just for the rich. No matter your financial status, taking time to think about your assets can alleviate family stress and conflict following your death.

The estate planning process comprises several components, each playing a specific role to ensure an efficient transfer of your assets after your death.

Wills

A will is a legal document that details where you would like your assets to go after you die. The document might also include information about the guardianship of minor children. If you do not prepare a will before death, your assets will be distributed based on state laws.

Trusts

Some estate plans include establishing a life insurance trust, which receives the proceeds of the policy after you die. You will name a trustee who will ensure the distribution of funds as desired. It’s common to create a life insurance trust for the benefit of minors or young adult children who might need the help of an adult in managing a significant windfall.

Power of Attorney

A power of attorney is a legal document that authorizes someone to act on your behalf in making legal and financial decisions if you are incapacitated. A similar document exists for medical purposes.

Timmerman said that for any power of attorney or other estate plan document you create, it’s important to make sure people close to you know where to access it: “It does not help to have these documents if no one knows that they exist or where to find them,” she said.

Life insurance can help your beneficiaries cover immediate expenses after your death, including medical bills, funeral costs and other final expenses. Your beneficiaries receive direct, quick access to the funds, avoiding the probate process, which can drag on due to complex legal formalities.

Having a life insurance policy can also make it easier for you to divide your assets among beneficiaries fairly. For instance, if one relative inherits the family business, the other can have proceeds from the life insurance policy. If you have a dependent with special needs, you can set up a trust to ensure the dependent will not face financial hardship after your death.

Naming Beneficiaries

Part of the estate planning process is choosing life insurance beneficiaries. Deciding who will inherit your assets can reduce legal disputes later on and ensure direct transfer according to your wishes.

You can designate primary and secondary beneficiaries to a life insurance policy. Primary beneficiaries are the first to receive your assets after you die. If they cannot accept the assets due to incapacity, death or refusal, secondary (or contingent) beneficiaries will then receive the assets. While it’s not mandatory to name contingent beneficiaries, it is worth considering.

It’s recommended to review and update your beneficiaries regularly, especially as your life circumstances change.

Using Trusts

Trusts provide many benefits in estate planning, including the opportunity to avoid probate — trust assets generally do not go through the probate process. Although you can set up many types of trusts, the most common ones include Irrevocable Life Insurance Trusts (ILITs) and Charitable Lead Trusts (CLTs).

When setting up an ILIT, you must name a trustee and beneficiaries. After your death, your life insurance funds are deposited in your trust. The trustee, or the third party handling the trust, will distribute the death benefit among your named beneficiaries according to the terms you set. Because ILITs are irrevocable, you lose control of the policy when you set it up, and you cannot easily modify or revoke its terms.

CLTs ensure payments to a charitable cause or organization you choose for a set period. After that period, the trustee will transfer your assets to your named beneficiaries.

You can choose between term life insurance, whole life insurance and universal life insurance for estate planning. The ideal policy will depend on your needs, financial circumstances and your life stage.

Term Life Insurance

Term life insurance provides a death benefit if you die during the policy’s term, which can range from five to 30 years. A term policy is ideal for short-term needs — say, until your children are through college or until your mortgage is paid off.

Whole Life Insurance

A whole life policy offers permanent coverage — meaning a death benefit is paid whenever you die, as long as premiums are paid — with level premiums for life. It also offers a cash value component that grows tax-deferred over time. You can use this policy for long-term needs, planning your legacy and transferring your wealth.

Universal Life Insurance

Universal life insurance, another type of permanent coverage, provides flexible premiums, death benefits and a cash value component. However, universal life policies come with more risk than whole life policies because the cash value growth depends on market conditions. Some people use universal life policies in estate planning to seek significant cash value growth, even if it’s risky.

The type — or types — of life insurance policies you incorporate in your estate plan is dependent on your needs, which are different for everyone. However, it’s wise to start thinking about your estate plan as early as possible, according to Jacob Tenney, a CFP® and assistant professor and director of financial planning at the University of Charleston.

“Many individuals don’t realize how important it is to plan early for the end of life,” Tenney said. “The key is to start now and stop putting it off. Too many people put off estate planning for a variety of reasons and then end up with difficult and uncomfortable situations for themselves and their loved ones.”

It’s also important to review your life insurance coverage at different stages of life and adjust it based on your circumstances.

The exact amount of life insurance coverage you need depends on a variety of factors. You can start by estimating how much money your beneficiaries might need to cover funeral expenses. You can also consider the amount your dependents might need for other expenses, like student loans, and future financial goals.

A financial advisor can give you personalized advice based on your situation.

Estimate Future Expenses

Think about the expenses you cover today that your loved ones will take over after your death. You might consider everyday expenses, funeral costs, a mortgage, loans, credit card debt and college education savings for dependent children.

In this process, you may learn that some expenses are pretty significant. For example, the average funeral costs $7,848 according to recent data from the National Funeral Directors Association. Or, if you still have to pay $250,000 for your mortgage loan, make sure your death benefit is large enough to pay the entire amount.

Factor in Taxes

Depending on your estate’s value, your beneficiaries may owe federal and state taxes. A life insurance policy can help pay these taxes without requiring your family to sell your assets.

Funds in retirement accounts like traditional IRAs and 401(k)s are also subject to taxes when withdrawn. A tax professional or estate tax lawyer can help you estimate your estate’s potential tax liability.

Incorporating a life insurance policy in an estate plan is not always straightforward. Even if you are working with an estate planning professional, it is important to be aware of the most common mistakes people make with their life insurance policies.

• Not having enough or the right type of coverage: Choosing the right type of policy for your family’s needs is essential. It is best to choose a coverage amount after analyzing your current financial situation, future goals and your dependents’ needs.
• Naming the estate as the beneficiary: If you designate your estate as the beneficiary, your family may go through a complicated probate process. It is often recommended to name trusts or specific individuals to transfer your assets efficiently.
• Not reviewing policies regularly: Your life circumstances will change over time, so it’s important to review your policy periodically and modify it after events including marriage, divorce and childbirth.
• Letting policies lapse: A lapse in your policy can leave you without coverage and result in significant costs to reinstate it. You can set up automatic payments to avoid a lapse due to non-payment.
• Not shopping for policies: A change in your situation and market conditions could often result in better rates or coverage, which is why it’s worth shopping around.
• Not discussing plans with family members: Discuss the estate planning process and your intentions with your family members to avoid confusion after your death.

Working with financial experts can help ensure efficient estate planning. Timmerman said having trusted advisors in your corner is even more important when your situation is irregular.

“If you have a family dynamic that requires special circumstances, getting a lawyer to draft that plan is very important,” Timmerman said.

To find qualified agents and advisors, you can ask for referrals from your friends, family or other professionals including accountants or attorneys. It is important to look for professionals who specialize in estate planning and have relevant certifications. Before working with an advisor, look for online reviews and understand their fee structure — you want to work with people who have your best interests in mind, not their own.

When you reach out to an estate planning professional, your first step is likely an initial consultation where you get to know each other and talk about your estate planning needs. They will then help you create plans that fit your needs and assist in the implementation. After you determine your estate plan or purchase life insurance, review and modify your strategies based on changing circumstances.

Life insurance can play a major role in estate planning by ensuring your beneficiaries have financial support after your death. With so many life insurance policy options available, and estate planning structures that come with legal and tax complexities, it’s important to work with trusted and reputable advisors.

Jacob Tenney: Jacob Tenney, Ph.D., CFP®, is an assistant professor and director of financial planning at the University of Charleston in Charleston, W. Va. Tenney teaches courses in financial planning, financial literacy and business finance. Jacob provides pro bono financial counseling to low-income individuals and families who are trying to get a better handle on their finances. Tenney is married with five children.

Inga Timmerman: Inga Timmerman, Ph.D., CFP®,  joined the Coggin College of Business at the University of North Florida in August 2022 as an assistant professor of finance. Timmerman’s research focuses on two areas: individual financial decision-making and issues related to the financial advising profession. A CFP®, Inga is a practicing academic who works with highly educated individuals on personal financial planning. She is the immediate past president of the Academy of Financial Services and the academic editor for the Journal of Financial Planning.