Estate Planning Basics – Life Insurance

Published On: March 21, 2024

Written by: Ben Atwater and Matt Malick

The first article in our “Estate Planning Basics” series addressed the three core documents of an estate plan – a Will, a Durable Health Care Power of Attorney and Advanced Health Care Directive (Living Will), and a Durable General Power of Attorney for Finances. In our second article, we turned our attention to probate and non-probate assets. Today, we focus on an important tool of estate planning, life insurance.

Life insurance, with a properly completed beneficiary designation, falls into the category of a non-probate asset. 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 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 life insurance should assist your family in replacing lost income, paying off debt (including your mortgage), funding education, addressing business succession needs, paying death taxes, supplementing future retirement income, etc.

A primary reason to buy life insurance is for income replacement. If your family is relying on your income, then you probably need life 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 purchase life insurance, the cheaper the premiums are.

To accomplish income replacement, most working spouses should have life insurance death benefits of five to ten times their total annual expenses. Or being aggressive, you can estimate the number of years until retirement and multiply that by your annual expenses to arrive at a number.

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 no longer need childcare.

Ideally, insurance proceeds should also cover all your debts or provide income replacement to cover your debt service. You should also consider planned education expenses for children.

Regardless, insurance can be expensive, and you will need to make decisions about what you can appropriately afford. It is unlikely, especially for high income earners, that you will be able to fully insure your risk.

As you build your savings, you can often reduce your necessary insurance by the amount of your savings. For example, based on the above, 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 key 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 address these insurance needs.

Life insurance is not taxable as income to the beneficiary. Under certain circumstances though you may owe an inheritance tax on life insurance proceeds. Pennsylvania does not assess an inheritance tax on life insurance proceeds. However, most life insurance proceeds would be subject to federal estate tax if the value of estate assets exceeds the estate and gift tax exemption threshold.

For a married couple to have a federally taxable estate their net worth must reach $27,220,000 in 2024 (a threshold that obviously applies to very few families). That said, this large exemption runs through 2025 by 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) plus an inflation adjustment. Without congressional action, the likely exemption for a couple post-2025 will be about $14,000,000.

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 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. You can also use permanent insurance for tax-free retirement income when the owner borrows from the policy.

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. It is sometimes only obvious in hindsight whether purchasing a whole life policy from a premier insurance company or purchasing cheaper term insurance was the right decision.

Bottom line, insurance is a big part of estate planning. Given major tax law changes coming after 2025, 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.