Understanding the Connection Between Life Insurance and Estate Planning

A common misconception people have about life insurance and estate planning is that they only need to designate their spouse, child, or loved one as the beneficiary of the life insurance policy to ensure that the benefits will be available to the beneficiary when they die.

Life insurance is an important financial and estate planning tool, but without certain protections in place, there is no guarantee that your beneficiary will receive, or keep, the benefit from your insurance.

Life Insurance and Estate Planning: 2 Scenarios

SCENARIO #1

Brad identified his wife, Jill, as the beneficiary of his life insurance policy. At Brad’s death, Jill does, in fact, receive the death benefit from the insurance policy, but when Jill remarries, she adds her new husband’s name as a joint owner of the bank account where she deposited the death benefit. In so doing, she inadvertently leaves the entire death benefit from Brad’s life insurance to her new husband instead of to the children she and Brad shared, as they had discussed before his death and as indicated in her will.

SCENARIO #2

Ebony, a single mother, named her ten-year-old son Mark as a beneficiary of her life insurance. She passes away when he is twelve. The court names a relative as a guardian (sometimes referred to as a conservator) for Mark until he is legally an adult. By the time Mark reaches his eighteenth birthday, his inheritance has been partially spent on court costs, attorney’s fees, and guardian’s fees. In addition, its value has not kept pace with inflation because of the restricted investment options available to guardians. Ebony had hoped that the life insurance proceeds would be available to pay for Mark’s college expenses, but because of the costs and lack of investment flexibility, there is less money available to Mark. Mark receives the remaining funds, spends them frivolously, and within a year or two has nothing left.

Name a Trust as the Beneficiary of Your Life Insurance

A common method for leaving money and property to loved ones in an estate plan is by titling assets so they are owned by the trust or making the trust the beneficiary of the account or property, with a spouse or child as the trust’s beneficiaries. The same approach may also be used for life insurance policy proceeds. Two popular ways to achieve this result are naming a revocable living trust as a beneficiary and setting up an irrevocable life insurance trust.

Revocable Living Trust

For individuals with accounts and property valued below the current lifetime estate tax exemption amount or who have already set up a trust, naming a revocable living trust as the beneficiary of a life insurance policy can be a useful option. Doing so simply adds the death benefit from the life insurance policy to what you already have in trust, payable only to the trust’s beneficiaries according to the instructions already in the trust agreement. The benefit of this approach is that it instantly coordinates your life insurance proceeds with the rest of your estate plan.

Irrevocable Life Insurance Trust

An irrevocable life insurance trust is an added layer of protection because it can both own the life insurance policy and be named as the beneficiary. You can create an irrevocable life insurance trust either by transferring ownership of an existing policy into the trust or by the trust purchasing a new policy. Using your annual gift tax exclusion, you make cash gifts to the trust to pay the insurance premiums. Upon your death, the trust receives the death benefit and the trustee distributes the money according to the instructions in the trust document. This strategy also allows you to remove the value of the life insurance policy and the death benefit from your taxable estate.

Despite the estate tax exemption currently being at a historic high, it is likely that the exemption amount will change under the current administration or sunset in 2026 at the latest. Therefore, if you have purchased life insurance, consider taking the extra step to ensure that your loved ones’ financial futures are secure. To discuss your best options for structuring your life insurance estate plan, call Andre O. McDonald, a knowledgeable Howard County, Montgomery County and District of Columbia estate planning, special-needs planning, veterans pension planning and Medicaid planning attorney, at (443) 741-1088; (301) 941-7809 or (202) 640-2133 to scheduel a consultation. We are here to help.

DISCLAIMER: THE INFORMATION POSTED ON THIS BLOG IS INTENDED FOR EDUCATIONAL PURPOSES ONLY AND IS NOT INTENDED TO CONVEY LEGAL, INSURANCE OR TAX ADVICE.