RETIREMENT TIPS: How to Use Life Insurance in Estate Planning

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By ALAN KONDO, CFP, CLU

Life insurance is typically a critical element of a family’s estate plan — it may enhance the amount of wealth you can bequeath to your heirs and provide a ready source of cash for post-death financial obligations.

If the value of your estate exceeds the federal estate tax threshold (for 2013, this amount is $5.25 million), this source of liquidity may reduce the likelihood that your heirs will be forced to sell assets to pay estate taxes. Even when you are not a multi-millionaire, life insurance can provide flexibility and liquidity when it is most needed.

When you designate an individual as beneficiary, life insurance proceeds are paid directly to the beneficiary. This avoids the cost and delay of probate. The beneficiary has quick access to a source of funds that may be used to pay expenses, such as lawyer’s fees, associated with settling your estate.

If the policy is payable to your estate instead, the proceeds are subject to probate the same as any other asset. Because the probate process for a complicated estate may take as long as a year, your heirs may have to wait longer before accessing the proceeds.

Proceeds from life insurance that are received by the beneficiaries upon the death of the insured are generally income tax free, except when:

● The insured has died within three years of transferring ownership.

● The proceeds of the policy are paid to the executor of the insured’s estate.

● The insured owned or partially owned the policy.

Therefore, it is important to structure your life insurance policy correctly before you purchase. It is much more difficult to change it afterwards. Consult with your Certified Financial Planner™ to evaluate your own life insurance strategy.

Transferring Your Policy

In order to ensure that the death benefit from your life insurance policy will be free of both income taxes and estate taxes, you may want to move the policy outside of your estate. This is accomplished by making sure the owner is someone other than yourself. If it is a new policy, you can structure it correctly from the outset. If it is an old policy you can transfer ownership in a couple of ways.

Transferring ownership of a life insurance policy entails a trade-off between control and taxes. Once you transfer ownership to another person, you relinquish control of the policy. If the new owner cashes in and terminates the policy before your death, you have no recourse. The new owner is obligated to pay premiums that may be due following the transfer. However if your children cannot afford to pay the premium themselves, you can periodically gift funds to be used as premium payments.

Another technique for transferring ownership is creating an irrevocable life insurance trust (also called an “ILIT”) that holds the policy. This trust enables you to stipulate that the policy be kept in effect for as long as you live. You designate a trustee who, upon your death, distributes the insurance proceeds to your heirs.

Business Value of Life Insurance

Many families also use life insurance proceeds as a tool for balancing an estate that includes ownership of a business. For example, an entrepreneur may find himself in the situation of planning an estate in which his two adult children — one who works in his business and one who does not — are his heirs. Many entrepreneurs in this situation will bequeath the business to the son or daughter who works there and designate the other as beneficiary of a life insurance policy whose value equals that of the business.

Many business owners rely on life insurance proceeds as part of a business continuation agreement (commonly known as a “buy-sell agreement”) that enables business partners to acquire the ownership interest of a deceased owner’s heirs. In this instance, the surviving owners use insurance proceeds to purchase the interest of heirs who have no intention of managing the business.

Estate and insurance planning are complex areas that require assistance from experienced professionals. It is important that your Certified Financial Planner™, CPA and estate planning attorney work collaboratively as a team in order to provide you with the best solutions.

The opinions expressed above are solely those of Kondo Wealth Advisors, LLC, a Registered Investment Advisor in the state of California. Neither Kondo Wealth Advisors, LLC nor its representatives provide legal, tax or accounting advice.

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