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Life Insurance Coverage for Estate Planning
Most people think of life insurance as merely a death benefit that pays out when the insured dies. But, in reality, life insurance is a very flexible financial tool that can do much more. In particular, life insurance is a tremendous estate planning tool that, when used properly, can be key in estate planning.
When you die, your estate will be responsible for paying taxes on any income you earned up to that point. This includes the disposal of all capital property, like investment portfolios, businesses, and real estate holdings. Depending on the size of your estate, this could result in significant capital gains taxes. Life insurance can help to alleviate some of this financial burden by providing a death benefit that can be used to pay any outstanding taxes owing. There are two areas of estate planning where life insurance can make a big difference:
- Creating an estate: Use one or multiple life insurance policies to create a tax-free estate that will pass to your heirs
- Preserving or maximizing an estate: Use the proceeds of life insurance to pay for estate taxes, final expenses, outstanding debts, and other obligations that could reduce the value of your estate.
Let’s cover in more detail how life insurance can be a valuable estate planning tool.
What is estate planning?
Estate planning is putting strategies in place to manage and transfer your estate after your death. Proper estate planning involves financial planning and tax strategies to transfer as much of your gross estate to your family members by using estate preservation tools such as life insurance products.
Estate planning also involves setting up the proper documents and giving specific instructions as to the disposition of your estate. This portion of your estate planning will involve financial advisors and estate attorneys to give you the right legal or tax advice.
How is life insurance used in estate planning?
Life insurance can offer significant value to form an integrated and comprehensive component of estate planning that will go far beyond simply paying a death benefit at the end of someone’s life. Life insurance has been used to deal with many aspects of planning, such as:
- paying final expenses
- settling debts
- providing for your loved ones when you are gone
- passing on your estate without taxes
- avoiding probate
- equalization of asset distribution to heirs.
These are the most important areas where life insurance helps with estate planning. Talk to your financial advisor and attorney for more detailed information applicable to your particular case.
Two of the most common uses for life insurance deal with taxes and probate fees. are the payment of taxes and paying probate fees.
How do you pass on your estate without paying taxes?
When you purchase a life insurance policy, you pay premiums to the company and, in exchange, they agree to pay a designated sum of money to your beneficiaries in the event of your death. Your beneficiaries can receive this death benefit free of any taxes because you have already paid income taxes on the premium payments. Another big advantage of life insurance is that the payouts go directly to your beneficiaries, bypassing your estate and the probate process. This means that if you have any outstanding debts at the time of your death, creditors will not be able to access the death benefit.
What are probate fees?
Probate is the legal process of sorting out your affairs and distributing your assets. Probate fees are the costs associated with having your will approved by the court. These fees can vary widely from province to province, but they typically range from a few hundred dollars to several thousand. In some provinces, such as Alberta, these fees are set by legislation and are uniform across the province. In others, such as Ontario, the probate fee is based on a sliding scale and is calculated as a percentage of the value of your estate.
Probate fees are typically paid by the executor of your will out of the funds in your estate. However, in some cases, your family may be required to pay these fees upfront. This is why it’s important to discuss probate fees with your life insurance agent before you purchase a policy. They can help you understand how these fees will be handled in the event of your death and ensure that your loved ones are prepared financially.
Why do probate fees matter?
Probate fees matter because they can have a significant impact on the amount of money that your loved ones will receive after you die. These fees can eat into the funds in your estate, leaving less money for your beneficiaries. In some cases, probate fees can even discourage people from contesting their will in court. This is why it’s important to have a clear understanding of how these fees will be handled before you purchase a life insurance policy.
Benefits of life insurance in estate planning
Estate Preservation: Estate preservation is particularly important if you have a large estate and want to ensure that your heirs receive the full value of your assets. By using life insurance to pay any estate taxes that may be owed, you can help reduce the amount of money that your heirs would otherwise have to pay out of their own pockets, thereby preserving the value of your estate for your loved ones.
Estate Maximization: If you want to maximize the value of your estate, life insurance can be a great way to do it. By using life insurance to pay for final expenses and other debts, you can free up more of your estate’s value for your heirs. And, if you structure your life insurance policy properly, you can even use it to help minimize taxes on your estate.
When putting together your financial plan, you will need to consult with a lawyer or financial advisor to ensure that what you set out to do will meet the law requirements. An insurance advisor will also be a key person in your team.
How does life insurance differ from a will or estate?
The biggest differences between receiving proceeds from a life insurance policy, a will, and an estate are the speed of execution and potential estate tax liabilities. For example, a life insurance policy typically pays out death benefits within 30 to 60 days if everything is in order. On the other hand, an estate can take months or years, as can a will if contested.
Then we have estate taxes to consider. Death benefit proceeds in life insurance are tax-free. However, in some cases, estates can be subject to capital gains tax, probate fees, and even regular income tax. The final tax bill on a sizable estate can be a big burden on the heirs. This is where estate planning with the right insurance policy can make a huge difference in the outcome when the insured dies.
What goes into your estate planning checklist?
When the time comes to begin planning your estate, you will need to consider many different aspects of financial planning so you can maximize your assets.
- Take inventory of all your possessions: Find out the fair market value of the real estate, art, collectibles, stock portfolios, bank accounts, registered retirement savings plans, jewellery, and any other valuables.
- Assess your family’s needs: Consider what your surviving spouse, children, and any other dependent family member will need to live on when you die. Plan so they can avoid the financial burden of your absence.
- Estate planning is about caring for your loved ones when you are no longer here. Make sure your estate plans include contingencies for expenses such as funeral costs, estate tax obligations, probate fees, etc.
- Establish legal directives such as trusts, a medical care directive, and adequate powers of attorney.
- Revisit your estate plan and documents and update them as needed. The beneficiaries are one of the most commonly overlooked updates to estate planning documents. Life changes often dictate selecting a different beneficiary due to death, divorce, and other life events. Make sure your insurance company has the most current designation of beneficiaries.
What type of life insurance is best for estate planning?
What type of life insurance policy and how much life insurance you buy will be determined by your financial strategy. A term life insurance policy and a permanent life insurance policy offer specific advantages that can fill strategic planning needs. Let’s look at some practical examples.
Let’s say that you have rental properties that you plan to transfer to your heirs, and they don’t favor the idea of being landlords. They would likely sell the properties when you die, and the cost of selling can be substantial, in addition to paying off existing mortgages.
You can purchase life insurance to cover the expenses of selling and paying off the mortgages, so they have the most cash out of the sale. You can accomplish this with permanent insurance such as a whole life insurance policy, or you can choose a term life insurance policy. Your decision may be influenced by things such as life insurance premiums for either term life insurance or a permanent life insurance policy.
Suppose you are a business owner with partners and liabilities you are personally responsible for. In that case, life insurance policies can offer indemnity to your partners via life insurance payouts to cover outstanding debts. For purposes such as this, you may even be able to have the premiums paid by the business.
Frequently Asked Questions
1. Is a life insurance policy part of an estate in Canada?
A life insurance policy is not automatically part of an estate in Canada. When you buy life insurance, the insurance company will request that you name a beneficiary or beneficiaries to receive the death benefit. A competent insurance advisor will guide you to make sure you understand the ramifications of naming your estate as the beneficiary of your insurance proceeds.
2. Is life insurance good for estate planning?
Yes, life insurance can help you in a multitude of ways when planning your estate. For example, you can use it to transfer wealth, pay probate fees, pay capital gains taxes, preserve the value of your estate, and so much more.
3. Can life insurance be part of an estate?
Yes, you can name your estate as the beneficiary of your life insurance policy, although it is not always recommended. However, the life insurance company will pay out the proceeds of the death benefit as you stipulate in your policy.
4. What happens when life insurance proceeds go to the estate?
When you name your estate as the beneficiary, the proceeds become part of your estate and will be distributed as required by the instructions of your will. Estate taxes and capital gains tax will then be applicable.
5. What are the most common objectives of using life insurance in an estate plan?
There are five areas where life insurance plays a key role in estate planning;
- Diversification: Life insurance allows the policy owner to diversify investments without correlation to traditional investment vehicles usually driven by the market.
- Competitive rates of return: Although there may be investments that offer a face rate of return that may be higher than the guaranteed rate of return on an insurance policy, there is a factor that will offset that spread by often a significant margin: taxes. When the insured dies, the death benefit is paid to the beneficiary or beneficiaries without having to pay taxes. In the end, comparing the rate of return of traditional investments after taxes and insurance proceeds without taxes will generally tip the scale in favor of buying life insurance.
- Guarantees: Many permanent life insurance policies offer a minimum guaranteed rate of return, ensuring that the cash value will continue to grow regardless of market conditions. Other investments tied to market conditions rarely offer any guarantee against the loss of principal.
- Tax-deferred growth: Permanent life insurance has a cash value component that grows tax-deferred over time. The accrued cash value can be borrowed against, which can be a great alternative to supplement your income instead of liquidating other assets.
- Liquidity: One of the great benefits of life insurance is the relatively short time it takes to receive the death benefit as long as the beneficiaries are listed on the insurance policy. Unlike a will or waiting for the settlement of an estate, the designated death benefit will be paid out much faster.
6. Is life insurance taxable to an estate?
Generally speaking, insurance proceeds are not taxable. However, make sure to check with your financial advisor to verify this is the case for you.
7. How do I keep my life insurance proceeds out of my estate?
The simplest way to keep life insurance proceeds from becoming part of your estate is to name a beneficiary on your life insurance other than your estate. Make sure your insurance provider is aware of your intent to not have your death benefit be part of your estate.
8. What does estate life insurance mean?
Estate life insurance can have a variety of meanings. A good starting point would be to define estate life insurance as life insurance to protect and maximize an estate when it is transferred to the beneficiary.
9. Should I name my estate as the beneficiary of my life insurance?
You can, in fact, name your estate as the beneficiary on your life insurance policy. However, it may not be the most cost-effective way to transfer your assets to your heirs. When the proceeds of your life insurance policy become part of your estate, there will be a significant tax bill that your heirs will have to pay. There may also be taxable capital gains and a probate fee, which you may avoid with proper estate planning.
Proper estate planning is crucial to making the most of the assets you will accumulate and transfer to your heirs. Life insurance, whether it be term life insurance or permanent whole life insurance, can shield your estate against undue taxes and fees. Life insurance for estate planning is a valuable strategy. It can be easily put in place as you start your estate plans.
Consult with an experienced and licensed professional who can give you the guidance necessary to choose the right products and strategies to protect your estate.