Estate Planning Basics – Life Insurance

Published On: May 18, 2020

Written by: Ben Atwater and Matt Malick

Back in February, when things were “normal,” we started writing a series on estate planning basics.  In the meantime, we have spent most of our efforts working through market volatility.  However, the COVID crisis has inspired some of us to reevaluate many aspects of our lives from our finances to our hobbies.  Given this enormous disruption and its ability to make us reflect, now is a great time to continue our series so you can better consider your estate plan at this pivotal moment. 

We encourage you to please reference our earlier articles.  Our first article covered core documents like wills, living wills, and powers of attorney (healthcare and financial).  Our second piece addressed probate and non-probate assets. 

Life insurance, with a properly completed beneficiary designation, falls into the category of non-probate assets.  This means that after the death of the insured, the life insurance proceeds pass directly to heirs without having to go through a legal process and should pass relatively quickly. 

For many of us, the most important aspect of protecting our family and solidifying our estate plan often involves owning life insurance.  The proper amount of insurance should assist your family in replacing lost income, paying off debt, funding education, addressing business succession needs, paying death taxes, etc. 

The number one reason to buy life insurance is for income replacement.  If someone is relying on your income, then you probably need insurance.  Companies underwrite life insurance to reflect the risk that they are undertaking, so the better your health, the lower your premium.  For younger investors with families, planning your life insurance should be as important as planning your retirement.  And the younger you are when you start to purchase life insurance, the cheaper the premiums. 

To accomplish income replacement, most working spouses should have life insurance death benefits of five to ten times their total annual compensation.  If one spouse is a homemaker and provides childcare, then you should consider covering him or her at the annual cost of such care times the number of years until your children are adults. 

Ideally, insurance proceeds should also cover all your debts or provide the income replacement to cover your debt service.  The same can be said for planned education expenses. 

As you build your savings, you can often reduce your necessary insurance by the amount of your savings.  For example, based on the above, say you estimate that you need $3 million for income replacement, debt and education and you have $1 million saved.  In this case you would need $2 million in death benefits. 

Small businesses should purchase life insurance policies for key individuals, such as an owner or top employee, to help prevent financial distress if that person were to die.  The death of a key person in a business can throw things into disarray.  Business owners must calculate the cost of this as well as related buyout expenses, if needed, when estimating insurance needs.  It is the responsibility of all the business owners to monitor and police these insurance needs.
 
Life insurance is generally tax-efficient and is not taxable as income to the beneficiary.  However, under certain circumstances you may owe an inheritance tax on life insurance proceeds.  Pennsylvania does not assess an inheritance tax on life insurance proceeds.  For a married couple to have a federally taxable estate their net worth must reach $23,160,000 in 2020 (a threshold that obviously applies to very few families).  That said, this large exemption runs through 2025 at which time Congress will need to write new legislation or the exemption will drop back to the pre-2018 level ($10,980,000 for a married couple). 

Life insurance policies fall into 2 general categories: term and permanent. A term insurance policy covers a specific period, such as 10 or 20 years.  At the end of that period, you normally stop paying premiums and your coverage ends.  Individuals use term insurance for replacing lost income, etc. in the event of premature death.  Term insurance is generally more affordable, and therefore more accessible, for many clients.   

A permanent insurance policy is typically meant to cover you until your death.  People use permanent insurance for wealth transfer, estate planning purposes and business succession. 

Anecdotally, we have seen insurance planning go in unanticipated directions.  For one, in several situations the insured purchased term insurance with the intention of building enough wealth over the term (say twenty years) whereby at expiration, they would no longer need the insurance.  However, too often the insured does not accumulate the savings they planned and when the term insurance expires, they still need coverage, but they find the coverage unaffordable.
 
We have also seen people who purchased whole life many years ago and, because of the “forced savings” nature of the premiums, have accumulated a nice cash value nest egg which has become an important part of their net worth. 

All things being equal, in our view, it is best to buy term insurance (because it is inexpensive) and “invest the rest.”  Too often, though, savers do not have the discipline to do this. 

Bottom line, insurance is a big part of estate planning.  Given all that is happening in the world, there has never been a better time to review your insurance planning and your broader estate plan.  If insurance or estate planning has been on your mind, please give us a call.  We would be grateful for the opportunity to further review your situation.