Estate planning plays a vital role in ensuring that your wealth is protected and passed on according to your wishes. One crucial element of estate planning is determining how much life insurance is necessary to cover debts, taxes, and other expenses that may arise after you’re gone. Life Insurance for Estate Planning helps you protect your loved ones, minimize estate taxes, and create liquidity for your heirs. But how do you determine how much life insurance you need?
In this guide, we will break down the factors that influence your life insurance needs and help you make an informed decision.
Why Life Insurance is Essential for Estate Planning
Rick’s Story: Protecting a Lifetime of Work
Rick, age 69, the owner of a successful public relations firm, was concerned about passing on the result of a lifetime of hard work to the generations that were succeeding him. Now that his kids were having kids of their own, it was becoming even more important to him that they be able to enjoy the fruits of his labor. As he approached his 70th birthday, Rick’s financial concerns revolved around preserving his wealth and minimizing his estate tax exposure in order to leave as much money as possible to his heirs.
At an annual meeting with his financial planner, it occurred to him that maxing out his retirement accounts each year wasn’t doing enough. It was a conflicting strategy: His high tax bracket was reducing the value of many of his other investing strategies, leaving him unsure about where to put his cash. He wanted to make sure that he was protecting what mattered most to him: his kids and grandkids. He didn’t want to see a lifetime of hard work divided up outside his family or eroded by exorbitant income taxes. What Rick needed to do was take a deeper look into life insurance.
For Rick and many other people, life insurance is about more than just getting money to your spouse or kids in the event of an untimely death. Having the right life insurance that is properly structured can be an important wealth building and tax saving strategy to help preserve your legacy for your family after your death. People who see life insurance as just a safety net for others in the case of personal tragedy often miss out on the very real tax benefits that come with investing in the right policy. Rethinking a life insurance strategy can help your loved ones keep what is rightfully theirs by providing several benefits.
Key Benefits of Life Insurance in Estate Planning
- Income replacement: This is the most traditional use of life insurance. If you haven’t put together a proper nest egg and were to die unexpectedly, life insurance can replace your income and provide money to pay for large expenses such as mortgages, college educations, and retirement.
- Estate tax liquidity: If you have saved enough money to make your family financially independent, or perhaps you recently came into more money by inheriting it from an older generation, life insurance can be used to pay the estate taxes that may eventually be due when you and your spouse die. Not only can life insurance create cash to pay for estate taxes, but it can also create the liquidity that is often necessary when family wealth is tied up in illiquid assets such as real estate or a business.
- Leveraging your estate: Life insurance can also be used to leverage the size of your estate. Rather than focusing solely on any estate taxes that may be due upon your death, life insurance can dramatically increase the amount of money you leave to your heirs by creating a tax-free rate of return that is often far in excess of traditional investments. This is especially true for people with large IRAs, annuities, and 401(k)s. Life policies that leverage these vehicles are often purchased inside of trusts, the details of which can be complex, so we encourage you to speak with us about exactly how to leverage the size of your estate using life insurance.
How to Calculate Your Life Insurance Needs for Estate Planning
Income Replacement Strategy
There are multiple ways to calculate the amount of life insurance you need for income replacement. One common approach is to multiply your annual family expenses by the number of years you wish to provide coverage. Let’s say your family needs $200,000 annually, and you’re planning to support them for 15 years. You’ll need approximately $3.5 million in life insurance coverage, factoring in inflation and rising costs over time.
$200,000 x 15 years = $3M + an extra $500K
…because, as we all know, expenses tend to go up over time, not down.
A second method would be to purchase $4 million of insurance so that, at a 5% rate of return, your family would receive $200k of income off of that principle every year. In this manner, you’re not only creating income—you are also creating an estate to be passed on to future generations.
What you don’t want to do is buy too little and leave your family in a position where they may run out of money down the road. Again, there are a few different ways to approach income replacement, so thinking through your needs with a pro can help.
EstateTax liquidity Strategy
you can try to estimate your estate tax exposure and buy a policy that will cover your anticipated tax bill. For example, if you had $10 million in assets at the time of your death but could only pass along $5 million tax-free, you would need a $2 million policy to cover the tax due on that additional $5 million of assets, which would be taxed at a rate of 40%. While that calculation may seem reasonably simple, there are some moving parts involved, such as constantly changing estate tax rules and the fluctuating value of your estate, which may include stocks, bonds, real estate, and other asset classes.
Leverage Strategy
You may actually “back into” the size of your policy based on your available income. What does that mean? If you were 60 years old and could comfortably afford to dedicate $60,000 to your policy each year for the rest of your life, that $60,000 may ultimately buy you a $4 million policy based on your health class, the insurer you chose, and a few other factors. That $4 million would pass tax-free to your heirs, creating a solid legacy while only costing you $1-2 million in premium payments (and perhaps even less) over your lifespan.
Common Pitfalls to Avoid
Underinsuring Your Estate The biggest mistake you can make is purchasing too little life insurance. If your policy falls short, your family might need to sell off valuable assets to cover estate taxes and debts, leaving them in a precarious financial position.
Not Updating Your Policy As estate tax laws change and your financial situation evolves, your life insurance needs may shift as well. It’s important to review your policy regularly with a professional to ensure it still meets your objectives.
Frequently Asked Questions (FAQs)
- What is the role of life insurance in estate planning? Life insurance helps cover estate taxes, replaces income, and ensures liquidity for your heirs, all while maximizing the wealth you pass on to future generations.
- How can life insurance minimize estate taxes? Life insurance can provide a cash infusion to cover estate taxes, preventing the need to sell off family assets or take out loans to pay the tax bill.
- How much life insurance do I need for estate planning? This depends on your income replacement needs, estate size, and tax exposure. Consult with an experienced advisor to assess the right coverage for your situation.
- Can life insurance policies be held in a trust? Yes, many life insurance policies are purchased inside of trusts to manage the death benefit distribution and maximize tax benefits.
- What is the cost of life insurance for estate planning? Costs vary based on factors like age, health, and the policy’s value. Your advisor can help you structure a policy that fits your budget and estate planning goals.
- How often should I review my life insurance policy? It’s recommended to review your life insurance policy at least once a year, or whenever there’s a major change in your financial situation or tax laws.
A Knowledgeable Advisor Can Help You Navigate Your Options
Given the complexities of Life Insurance for Estate Planning, with so many potential variables, it’s important you work with an experienced advisor who listens to you, understands your specific needs and will help tailor the perfect policy. Call and speak with one of the experienced advisors at Howard Kaye today to discuss strategies for safeguarding your legacy.
