Life insurance can play a vital role in an estate plan because the insurance proceeds can be relied on to provide liquidity when needed. With proper planning, insurance money can pay for expenses like inheritance taxes and keep other assets intact.
Suppose, for example, that Bill Smith dies and leaves a large estate to his daughter Julia. A significant property tax is due. However, most of Bill’s assets are tied to real estate and an IRA. Julia might not want to rush into a forced sale of real estate. However, if she uses the legacy IRA to raise funds, she will have to pay income tax on the withdrawal and lose a valuable extended tax deferral opportunity.
Anticipating such an outcome, Bill could purchase insurance on his own life. The proceeds can be used to pay the inheritance tax bill. Then Julia can keep the real estate while taking only the minimum distributions required from the inherited IRA. If the insurance policy is owned by Julia or a trust, the proceeds likely will not be included in Bill’s estate and will not increase the estate tax liability.
However, some common life insurance mistakes can ruin your estate plan:
* Designation of your estate as beneficiary. This places the policy proceeds in your estate, where the money will be exposed to estate tax and your creditors. Plus, your executor will face more paperwork if your estate is the beneficiary. So you need to make sure you name the right people or charities.
* Name a single beneficiary. You should name at least two “secondary” beneficiaries, to reduce confusion in case the primary beneficiary dies before you do.
* Put your life insurance in the “file and forget” drawer. You should check your policies at least once every three years. If the beneficiary is an ex-spouse or a deceased person, you must make the appropriate change and get written confirmation from the insurance company.
* Carry inadequate insurance. If you have a young child, you will likely need hundreds of thousands of dollars to pay for all of their expenses, including college bills, in the event of an untimely death. Slightly over insurance can penalize your survivors and such savings are probably not needed today with term insurance costs so low.
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