Tuesday, March 25, 2008

Using life insurance as part of your estate planning

Let's look at an example. A man and woman have no debt, and some money saved for their funeral expenses. They do not have life insurance. When they pass on, their children are able to pay for their funeral, however, they get hit with estate taxes for the large home, and other parts of the estate that they inherit. The huge burden of these taxes forces them to live in near poverty.

These parents in this example thought they had things taken care of with their no debts and money for funeral expenses. What they forgot was that anything their family inherits is taxed. Estate taxes come due nine months after a death. This is not much time if your heirs need to settle a largely illiquid estate. They may owe taxes on a huge property that they can not sell. What then?

One potential solution that should likely be apart of your estate planning is to buy a permanent life insurance policy that will cover estate taxes and provide your heirs with immediate cash, so they don't have to unload your business, home, etc. in a fire sale.

When you are young, buying life insurance that is permanent does not make sense, as it can cost up to eight times as much as a term policy. However, the point of a term policy is to provide children with money if their parent's die while the children are still young. For estate planning, the concern is not living expenses for young children, but the taxes and other expenses that come with settling an estate. Thus, for this purpose a policy that does not expire is a better plan.

Most people think whole life insurance is a terrible thing to buy, especially when life insurance companies try to sell it as an investment option. Life insurance isn't a great investment; if your primary goal is to get a good return, you'd almost certainly do better in a low-fee mutual fund. But it can be a valuable part of an estate plan, especially if you put it in a trust so it won't trigger estate taxes.

So, with these things in mind, let's take a look at a guide for permanent life insurance:

1. Pick a policy. There are three types of permanent insurance: whole, universal, and variable. Whole is the most conservative and generally the most expensive. Universal is riskier, and your premiums can get higher as you get older. Variable policies are the riskiest, because the cash value account is invested in the stock market, and you control the investments. So, if you are buying life insurance for estate planning, consider buying a second-to-die policy, which kicks in only when it's needed--when the second spouse dies. Variable, universal, and whole policies can all be designed as second-to-die plans.
2. Review your policy at least once a year. Then have your financial adviser review it.
3. Decide whether you need a trust. The rule of thumb is that if you have a net worth of more than $2 million--the point at which federal estate taxes kick in-put your policy in a trust so your heirs won't have to pay estate taxes on it. Only an irrevocable trust will protect your heirs from estate taxes.
4. Decide how much to buy. Determine your current net worth and how much it's likely to grow, then consider the nine-month IRS deadline, you'll need more insurance if a large portion of your estate is in illiquid assets, such as a business.
5. Find the best deal on insurance, watch out for commissions, fees, and more.
6. Put it in a trust sooner than later. If you die within three years of putting it in a trust, it is still considered part of your estate, and can be a real mess to sort out.