Life insurance is a great tool for estate planning. However, there are nuances that sometimes get overlooked which, if left unchecked, can reduce its potential considerably.
Assess the Need Properly
The amount of life insurance you need for estate planning is unique to each person’s financial and family circumstances. Remember that life insurance death benefits are used for more than just replacing immediate income from the family breadwinners. They can also pay off mortgage and other debts, cover college tuition, create a retirement nest egg for a surviving spouse, fund a business transfer, or be an important estate planning tool for paying estate and other taxes.
Families of all kinds need life insurance, including non-nuclear families and single income families. In the event of divorce with future child and spousal support obligations, the divorce settlement agreement should say that the ex-spouse, as payor, must maintain a sufficient life insurance policy naming the payee spouse, as the recipient-beneficiary, to cover all future commitments in the event of a premature death. The payee should also be notified by the insurance company of any policy changes or lapses, because she (or he) may be depending on this money if something were to happen. Stay-at-home spouses and caregivers also need life insurance, because replacing their duties could incur many unexpected costs for the survivor.
Designate Beneficiaries Properly
Effectively designating beneficiaries for life insurance is key. Here are some do’s and don’ts when naming a beneficiary:
DO designate named adult individuals or a trust to avoid probate on the death benefits of life insurance;
DON’T designate your estate, because this will lead to proceeds becoming involved in probate, which means that attorney's fees in probate will eat away at the proceeds and also allows creditors to place claims against those proceeds;
DON’T designate minors as beneficiaries, because assets will be paid outright to them as soon as they reach the age of majority in their state; and
DON’T designate a special-needs adult or child directly, because this may disqualify them from government benefits.
Designating a trust as beneficiary for minor children, special-needs individuals, or a person with limited financial wherewithal lets you maintain control. Work with an estate attorney to establish the appropriate trust for your intended purpose. Remember however, if you’re the trust owner and the insured, the death benefit will be included in your gross estate for tax purposes. That means, for people with taxable estates who are buying life insurance for the purpose of having guaranteed liquid funds available to pay future estate taxes when they die, they will be getting taxed on the very life insurance proceeds they were counting on to pay taxes with in the first place. However, having life insurance owned by an irrevocable life insurance trust (ILIT) removes the death benefit proceeds from the insured’s estate (unless the three-year-look-back rule applies to policies issued before the ILIT is in place).
Having life insurance owned by an ILIT may be particularly important in the coming years if the federal estate tax exemption is reduced to $5 million (adjusted for inflation) in 2026, or even lower if more aggressive legislation is implemented before then. The reason the ILIT is helpful in that regard is because life insurance proceeds won’t count against the federal exemption amount (whatever that amount happens to be) if the policy is owned by a properly drafted and maintained ILIT.
Know the Type(s) of Life Insurance
The main types of life insurance are whole life, term, and universal life. When acquiring life insurance, be sure to work with a professional who is highly experienced and knowledgeable, and who has the moral compass to keep your best interests at heart, so that you get set up with the type of insurance that is most suitable for your situation both short and long term.
Your situation may be best suited for a combination of both a whole life and a term life policy, or a whole life policy with a term life rider. When purchasing term life insurance, especially if that is all that you are going to get, be sure and go with a company that will allow you to "convert" all or a portion of the term insurance into permanent life insurance without further medical underwriting, and preferably throughout the entire term (e.g. 20 years). Convertible term insurance allows you to obtain more coverage at a lower initial cost while also guaranteeing your insurability in the future if you wish to convert some or all of that term insurance to a permanent product such as whole life.
Be careful with universal life or "flexible premium" policies. While they can be good in some instances if properly structured and maintained, all too often the cost of insurance inside of the policy can eat away at the cash value to the point that it significantly reduces or even eliminates the death benefit.
We help many of our clients obtain life insurance and/or replace policies they currently have that may be underperforming or inefficient. Please let us know if you require assistance in that regard.
Be Aware of Policy Exclusions
The following universal exclusions may prevent the beneficiaries of life insurance from receiving their intended death benefits:
The contestability period is a predetermined time period (usually two years from the date of issuance) where an insurance company can contest any information you submitted, and even cancel coverage or deny a claim, if there were misstatements or omissions made on the life insurance application. If you die during the contestability period and it’s shown that you made misrepresentations on your application, your claim can be denied—even if the cause of death had nothing to do with the actual misrepresentation.
Material misrepresentation is intentionally withholding material information or providing false information to the insurance company, that would’ve resulted in them not insuring you or insuring you under different terms. It extends during the entire policy term, because life insurance claims can be denied after the contestability period ends if fraud was committed to obtain the policy.
A suicide clause is included in nearly all life insurance contracts. The company won’t pay the death benefit and return premiums if the insured commits suicide within the first two years of the policy.
Some exclusions that aren’t universal but may be in the fine print of your life insurance policy include: illegal activity/committing a crime, dangerous activities (like sky diving or car racing), alcohol and/or drug use, and an aviation exclusion for private plane travel.
Using life insurance in estate planning is a great tool to protect your loved ones. So remember to review your life insurance needs regularly, and to maintain beneficiaries (and potentially even ownership of the policy) as warranted by your situation.