Life insurance can play an important role in estate planning. It is important to understand the uses and purposes of life insurance and the tax consequences of owning a policy and receiving a death benefit.

Income Replacement
One of the most common uses of life insurance is to replace lost income of a spouse. The difficulties of losing a spouse can be compounded greatly by the loss of a spouse’s income. One of the key features of life insurance is that the receipt of the death benefit generally is not taxable income to the beneficiary (the death benefit is taxable income if there has been a “transfer for value” of the policy). Therefore, the life insurance death benefit can provide financial stability to the insured’s family.

Clients should also not lose sight of the value of a spouse not in the workforce. Life insurance is often acquired on the life of the “stay-at-home” parent to provide financial resources to the employed spouse if there is an unexpected death. The value of the contributions of the stay-at-home parent should not be underestimated.

Tax Mitigation
A common planning purpose for life insurance is to purchase a policy with the idea that the death benefit will be used to pay federal estate tax or to replace the value of other assets used for this purpose. The federal estate tax exemption amount currently is $5,430,000 per person. Although the death benefit of a life insurance policy is part of the decedent’s taxable estate, fewer persons are subject to this tax than in the past. This planning use of life insurance, therefore, is not as widespread as in the past. Some clients, though, set up “Life Insurance Trusts” in the past when the estate tax exemption amount was much lower. It is prudent to review these arrangements to make sure the ownership of the policy should be continued, whether in the trust or otherwise.

We are often asked by clients how to avoid the Pennsylvania inheritance tax. Pennsylvania unfortunately does not have an exemption amount like the federal estate tax. However, the inheritance tax does not apply to a life insurance death benefit, so funding a life insurance policy is one way of taking a taxable asset (cash) and converting it into a non-taxable asset (the death benefit).

Funding Buy-Sell Obligations

Life insurance often is acquired by business owners to provide funds to carry out a buy-sell obligation between the owners. The death benefit provides the liquidity needed to close the purchase and sale of the business interest and to allow the surviving business owner to focus on operating the business.

Types of Life Insurance Policies

A variety of life insurance products are available, and the determination of which product is best for you should be made in consultation with your professional advisors. For example, a term life insurance policy may be best suited for you or you may want a policy that has cash value (whole life or universal life). You should also consider whether the policy will insure one life or will insure joint lives. A “second-to-die” policy often is purchased by spouses to pay estate tax since most estate plans defer the payment of estate tax until the death of both spouses. There may also be options regarding premium payments, policy loans, surrender charges, and contract riders. It is important to note that life insurance is regulated at the state level, so the policies that are issued are approved in advance by the Department of Insurance. Nevertheless, selecting the right type of policy can be complex given the variety of choices in the market, so it is important to consult with your professional advisors when purchasing life insurance.

Policy Ownership

Generally speaking, the life insurance policy should be owned by the insured, by a trust, or by the insured’s business party (for a buy-sell). Occasionally, we will see a client who owns life insurance insuring the life of another person, such as a child or a spouse. Although there is nothing wrong with these arrangements, the risk is that the owner of the policy will die before the insured party. If so, the life insurance contract will be part of the deceased owner’s estate and the disposition of the policy will be controlled by his or her Last Will and Testament. As noted above, in some cases the transfer of a life insurance policy will be a “transfer for value.” If there is a transfer for value, then the death benefit is taxable income to the beneficiary. A transfer for value occurs if, upon the death of the policy owner, the life insurance policy is transferred to anyone other than the insured party.

Some clients will seek to exclude the death benefit of a life insurance policy from the their estate (and therefore escape federal estate tax) by having their children own the life insurance policy insuring the client’s life. There is nothing wrong with this arrangement either, but the risk is that the child will go through a divorce or bankruptcy. The life insurance policy is property owned by the child that any creditor, such as a divorcing spouse or a bank, may go after.

Conclusion

Life insurance can be an important part of your estate plan. Its uses and purposes will vary based on a client’s situation. Each client, in consultation with his or her professional advisors, should be sure to understand the purpose and function of the life insurance being acquired as well as the type of policy being acquired.

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