Life insurance has long been a part of estate planning in the United States. Although life insurance does not need to be a part of every person's estate plan, it can be useful, especially for parents of young children and those who support a spouse or a disabled adult or child.
In addition to helping to support dependents, life insurance can help provide immediate cash at death. Insurance proceeds are a handy source of cash to pay the deceased's debts, funeral expenses, and income or estate taxes.
People who have no minor children or financially strapped dependents may not need life insurance. Below you'll find questions to ask yourself to help evaluate your life insurance needs. If you decide to purchase insurance, you should know exactly why you are buying it and choose the best type of policy for your needs. And, of course, you should buy no more than you need.
To determine whether it makes sense for you to buy insurance to provide financial help for family members over the long term, consider these questions:
How many people depend on your earning capacity? If the answer is "none," you probably don't need life insurance.
How much money would your dependents need for living expenses? One way to determine this amount is to look at the earned income that you bring to your dependents on a regular basis. From that amount, subtract the worth of property they would inherit from you and any amounts that will be available from public sources or private insurance plans that already provide coverage. Social Security survivors and dependents benefits will probably be available, and you may also be covered by union or management pensions, or a group life insurance plan. Also subtract any other likely sources of income, such as the help reasonably affluent grandparents would provide for your children in case of disaster.
How long would it take for your dependents to be come self-sufficient? If your children are almost out of college, they may not need much additional income. If they're younger, remember that dependent spouses caring for young children can usually return to work at some point, and some kids may get at least partial scholarships.
Once you perform this exercise, you may find that your dependents may need little additional income from life insurance. But if you have young children, you may find that it makes sense to buy an affordable amount of life insurance. For more information, see Using Life Insurance to Provide for Your Children.
Now, assess whether you need life insurance for short-term needs:
What assets will be available to take care of your dependents' immediate financial needs? You might leave some money in joint or pay-on-death bank accounts, or place marketable stocks in joint tenancy or register them on beneficiary (transfer-on-death) forms. For more information, see How to Avoid Probate.
After you die, how long will it be before your property is turned over to your inheritors? If most of your property will avoid probate, there's usually little need for insurance for short-term expenses, unless you have no bank accounts, securities, or other cash assets. By contrast, if the bulk of your property is transferred by will and therefore will be tied up in probate for months, your family and other inheritors may need the ready cash insurance can provide. While a probate court will usually promptly authorize a family allowance or otherwise allow a spouse or other inheritor access to estate funds, it can still be nice to have insurance proceeds available.
Will your estate owe substantial debts and taxes after your death? Lawyers and financial advisors call cash and assets that can quickly be converted to cash "liquid." If your estate has almost all "non-liquid" assets (real estate, collectibles, a share in a small business, jewelry), there may be a significant financial loss if these assets must be sold quickly to raise cash to pay bills, as opposed to what they could be sold for later if there had been enough liquid money from insurance or other sources to meet all pressing bills. Obviously, if your estate has significant funds in bank accounts or marketable securities, you won't need insurance for this purpose. Fortunately, federal estate taxes aren't due until nine months after death, so cash to pay them doesn't have to be raised immediately.
Avoid Probate and Estate Taxes on Life Insurance
Avoiding probate. The proceeds of a life insurance policy are not subject to probate unless you name your estate as the beneficiary of the policy. If anyone else, including a trust, is the beneficiary of the policy, the proceeds are not included in the probate estate and can be quickly transferred to survivors with little red tape, cost, or delay. Except when your estate will have no ready cash to pay anticipated debts and taxes, there is no sound reason for naming your estate, rather than a person, as the beneficiary of your life insurance policy. (For a more detailed discussion of the advantages of avoiding the probate process, see Why Avoid Probate?)
Avoiding estate taxes. If you own your insurance policy at the time you die, the proceeds are included in your taxable estate. If your estate is large enough to face estate tax liability (at least over $2 million), your life insurance proceeds will be subject to estate tax. On the other hand, if you don't legally own your life insurance policy, the proceeds are excluded from your taxable estate. This can significantly reduce your death tax liability. For more information, see Transfer Your Life Insurance and Decrease Your Estate Tax.
If you've determined that life insurance is right for you, you can learn about different types of insurance policies in Life Insurance Options. Or, if you already know the type of policy you need, go to How to Buy Life Insurance for tips on purchasing the coverage you need.
If you are the sole owner of a business, how much cash will it need when you die? Do you want and expect that some of your inheritors will continue the business? If so, do you think there will be enough cash flow for them to successfully maintain the business? You may need insurance proceeds to cover any cash flow shortage of the business. Will there be liquid funds to pay estate taxes?
If your inheritors won't continue the business, the questions are different: How much is your death likely to affect the value of the business? Will there be enough cash to keep the business alive until it is sold?
If you are one of several co-owners, life insurance proceeds can be used to buy out co-owners' interests. For more information on using life insurance to fund buyouts, see Business Buyout Agreements: A Step-by-Step Guide for Co-Owners, by Anthony Mancuso and Bethany K. Laurence (Nolo).