How Much Life Insurance Do I Need in My Estate Plan?

Life insurance: you know you need it, especially if you have minor children or other loved ones who depend on your financial support. Life insurance serves many functions in an estate plan, including providing a source of support to family, ensuring minor children will have the resources to go to college, and assuring the estate is liquid enough to pay taxes or debts without selling assets. If there is a family farm or business that only some of your heirs will want to continue to operate, life insurance can mean there is enough liquidity in the estate for them to buy the other heirs out.

How much life insurance do you need? What type of life insurance is best? And whose name should the policy be in—or should it be in a trust (and if so, what kind of trust)? Let's take a look at some of the considerations you should keep in mind when including life insurance in your estate plan.

How Much Life Insurance Do You Need (and What Kind)?

There are multiple types of life insurance. Term life insurance, as the name suggests, is insurance that pays a benefit if the insured dies within a specific period of time. Whole life insurance typically has a higher premium than term life, but the policy accumulates a cash value and pays out no matter when you die. Universal life, like whole life, is a permanent type of policy, but with more flexibility.

Speak with your estate planning attorney regarding what you hope to achieve with your life insurance policy; they will be able to help you identify the right type of policy and the amount of death benefit you need. In making this determination, you'll be considering the following questions: how much money will be needed immediately upon your death for final expenses and other obligations? How much will be needed to sustain your family going forward? Are there children whose education you need to provide for? How important is it that there are significant liquid assets available, say, to compensate one heir because the other is inheriting the family business?

The type of life insurance you need will be dictated by your reason for having it. If you're looking at life insurance for income replacement because you have a young family, a term life insurance policy may be most affordable. If you are only worried about having coverage to pay for your funeral, burial, and final medical expenses, a modest whole-life or universal life policy might be a good fit.

Who Should Own the Life Insurance Policy?

Whom the policy owner is affects whether the death benefits are subject to income tax and estate tax. As a general rule, life insurance isn't subject to income tax. On the other hand, as a general rule, life insurance is subject to federal estate tax. If the deceased person (decedent) possessed incidents of ownership in the policy, including the right to name or change beneficiaries, to assign or terminate the policy, and to borrow against the cash value of the policy, then it is subject to federal estate tax. Also, the benefits may be taxable if there has been a transfer of ownership within three years of death or if the death benefit is payable to the decedent's estate.

There is something of a trade-off: the more control you maintain over the policy during your life, the more likely the benefits may be subject to estate tax upon your death. This can be avoided with the use of an irrevocable life insurance trust. Because someone else must serve as trustee of the trust, once you place the policy in the name of the trust, you no longer retain the incidents of ownership discussed above.

It's wise to discuss not only the amount and type of life insurance you have, but how it will be owned, with your estate planning attorney. Unlike an insurance agent, an estate planning attorney will help you consider the tax aspects of this decision, so that your life insurance benefit is available when it's needed, to those who need it most.

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