Insurance Can Play a Big Role in Estate Planning

February 15, 2008

Even if you have updated your will, trusts and powers of attorney, your estate plan isn't complete until you've reviewed your insurance needs. The most important kind of policy for estate planning is life insurance, of course. But disability and long-term-care policies may also play a role by helping you pass more of your wealth to your heirs.

Here's a summary of the estate planning benefits of these three insurance types.

Life Insurance

One reason to buy life insurance is to replace the income your family will lose if you die prematurely. If you have minor children or lots of debt, your family would be devastated by the sudden loss of their primary income source. Life insurance should provide enough money to cover surviving family members' living expenses, tuition and loan repayments.

A second reason for buying life insurance is to provide cash to pay estate tax --assuming the tax is still in effect when you die -- if your estate consists mostly of illiquid assets. Suppose you've invested most of your savings in a closely held business. Without insurance proceeds, your heirs may have to sell your business, possibly at a fire-sale price, to pay the tax. Life insurance can also fund a buy-sell agreement to provide cash for your company to buy deceased owners' shares from their estates.

Married couples can choose between traditional individual life policies or second-to-die policies. The latter covers both spouses and pays off only after both die. Second-to-die premiums are generally lower than premiums on individual life policies because underwriters combine both spouses' life expectancies. When the second spouse dies, heirs can use the proceeds from the second-to-die policy to pay any estate tax still in effect.

Disability Insurance

When you think of estate planning, you usually think of issues related to death and inheritance. Although disability is not a death-related issue, it is still part of a good estate plan.

Disability insurance serves only one purpose, aside from providing peace of mind: income replacement (not liquidity). If your family's main breadwinner becomes unable to earn an income because of illness or injury, you'll need to replace that income. Without it, your heirs may have to "mine" your estate assets to cover living expenses, depleting your estate.

Disability insurance usually covers a percentage of your earned income -- not unearned income such as interest and dividends. Both group and individual policies are available. But employer-funded group policies are less flexible -- you can tailor individual policies to fit the insured's needs. Premiums vary with the level of benefits and with how the policy defines disability.

Business owners should consider a special type of disability policy called disability-buyout insurance. This policy provides funds for the company to buy disabled owners' shares in case they become permanently and totally disabled.

Long-Term-Care Insurance

Contrary to popular belief, Medicare pays less than 2% of nursing-home costs. When you plan your estate, consider whether you need long-term-care insurance. It covers at least some of the costs of assisted living or skilled nursing care if you become unable to live independently.

Another popular belief is that only people over age 65 need long-term care. In fact, 40% of those receiving long-term care are under 65.

Long-term-care insurance benefits and premiums vary widely and depend on your age and health when you apply for the policy. A good rule of thumb is to apply when you're in your 60s, assuming you can afford the premiums.

Applying when you're younger than 60 usually means you're paying for a longer time, and applying after 80 will mean sky-high premiums.

Another rule of thumb is that if your net worth is between $0.5 million and $1.5 million, long-term-care insurance is an option. But if your net worth is more than roughly $1.5 million, you might be better off not buying insurance and paying for long-term care yourself.

Life Insurance and Estate And Capital Gains Taxes

Another common use of insurance in estate planning is to provide liquidity to pay estate tax. Because the Economic Growth & Tax Relief Reconciliation Act of 2001 repeals the estate tax, you may think you no longer need insurance for this purpose. But consider the following.

First, the repeal is gradual. The act will reduce the estate tax beginning Jan. 1, 2002, and end the tax altogether Jan. 1, 2010.

Second, the estate-tax provisions in the tax bill "sunset" on Dec. 31, 2010. This means that the estate tax will be revived Jan. 1, 2011, unless Congress changes the law. Third, the act also partly eliminates the "step-up" in basis on appreciated assets that the estate-tax rules now allow. Here's how these rules work.

Let's say you leave to your daughter an asset, such as stock shares, that is worth much more on the day you die than you paid for it. When she sells the asset, her capital gain won't be based on what you paid for the asset, but rather on its value on your death date. Your daughter's basis is "stepped up" to the value on your death. She'll owe capital gains tax on the difference between what she sold the asset for and its value on the day you died. Without the "step-up," she'd be taxed instead on the difference between what she received for it and what you paid for it originally. Life insurance can help fund these potentially big estate or capital gains tax bills.

Planning Is Key

Now is a good time to review your estate plan with an eye to how insurance can help meet your needs. If you're in doubt about what kinds of policies you need, be sure to consult your legal and financial advisers for an unbiased appraisal.

Irrevocable Life Insurance Trusts

What if the estate tax is still in effect and your estate is worth more than the unified credit exclusion -- $675,000 in 2001 and $1 million in 2002? Then you can hold your life insurance policy in an irrevocable trust to reduce your tax. Holding the policy in trust puts it outside your estate for estate-tax purposes.