Why Life Insurance Works Best in a Trust
Life insurance can help heirs avoid having to incur expenses like estate taxes, funeral costs, and similar expenses. However, it also gives heirs breathing room so they can make the best use of other assets.
Here is an example of how life insurance should work. A father, Howie, dies and leaves a large estate to daughter Eva. The estate is large enough that it triggers a huge estate tax. However, the bulk of his assets are tied up in an IRA and real estate properties, some of which could be put on the market quickly, but not quickly enough for tax deadlines.
With that scenario, Eva might not want to immediately force a sale of the real estate. However, if she accesses the inherited IRA to raise money, she’ll have to pay income tax on the withdrawal and lose a terrific opportunity for extended tax deferral.
Considering this type of scenario, Howie could purchase insurance on himself.
The proceeds from Howie’s life insurance policy would then be used to pay the estate tax bill. With that taken care of, Eva could keep the real estate while taking the only minimum required distributions from the inherited IRA.
If the insurance policy is owned by Eva or by a trust, the proceeds probably will not be included in Howie’s estate and will not increase the estate tax obligation.
That’s a smart way to plan it out. However, some life insurance errors can wreak havoc with an estate plan. Let’s look at some common mistakes:
Naming your estate as beneficiary. This puts the proceeds in your estate—and the money will be exposed to estate tax and your creditors. Your executor will also have more paperwork if your estate is the beneficiary. Instead, designate the appropriate people or charities.
Designating a single beneficiary. Always name at least two contingent or “backup” beneficiaries, which will decrease or eliminate any confusion if the primary beneficiary predeceases you.
Filing and forgetting the policy. Review your policies every three years. If the beneficiary is an ex-spouse or someone who’s died, make the appropriate change and get a confirmation, in writing, from the insurance company.
Failing to have enough coverage. People often underestimate the amount of money needed to replace their income. Young children need caregivers if the main breadwinner dies and the surviving spouse has to work. The cost of college is only rising, and if you have smart kids, you want them to go to a good college—or at least have that option. You’ll need enough coverage for raising children, including college and caregiving. Don’t stint on the life insurance. It is money well spent.
Reference: FedWeek (February 14, 2019) “Common Mistakes in Life Insurance Designations”