Using Life Insurance for Estate Planning

The following is a guest post from Joel Ohman at Insurance Providers. Joel is a Certified Financial Plannerâ„¢ and somewhat of an Internet nerd/serial entrepreneur depending upon who you ask.

One of the best tools that estate planning attorneys, financial planners, and CPA’s have at their disposal for estate planning is life insurance. Estate plans big and small, complex to simple, and extraordinary to typical almost always involve some form of life insurance policy to complete the estate plan. Here are some of various things to understand about using life insurance in the estate planning process as well as tips for what type of strategies you may want to investigate further when crafting your estate plan.

One Common Misconception About Life Insurance

Before diving into some of the various ways that life insurance is used in estate planning it is worth pointing out a not insignificant issue that involves life insurance and estate taxes.

“The great thing about life insurance is that the death benefit that is paid out is tax free!” – have you ever heard that statement before? Many people say it and if you have ever listened to a sales pitch from a life insurance agent then no doubt covering the tax advantages of life insurance was one of their key talking points.

However, many people do not realize that the above statement is not necessarily true. The great thing about life insurance is that the death benefit is paid out income tax free and not necessarily tax free altogether as life insurance proceeds are typically included into the gross estate of the decedent (the deceased) and are thus subject to estate taxes (sometimes called “death taxes”).

In a Nutshell: Why Use Life Insurance for Estate Planning?

If you get nothing else from this article then please understand this one thing: the reason why life insurance is so valuable as an estate planning tool is that life insurance allows one to guarantee that a lump sum of money will be available upon their death to be directed in a way that will provide maximum benefit to their estate. This is just a fancy way of saying that many very wealthy people have a lot of their wealth tied up in non liquid assets like houses, property, businesses, etc. that if their estate was forced to liquidate some or all of those assets at death then they would likely greatly inconvenience the beneficiaries of the estate at best or at worst force a very unwise business decision (selling a business before the ideal time, being forced to quickly sell a piece of land, etc. – all in order to pay estate taxes due). Using life insurance in estate planning gives enormous freedom to those who upon their death may be ultra wealthy but relatively cash poor.

Life Insurance Estate Planning Strategy #1: Credit Shelter Trust

The first very practical way to use life insurance in estate planning that we will take a look at is the credit shelter trust (also known as a “by-pass” trust or “exemption” trust). The purpose of the credit shelter trust is to fully utilize the estate tax unified credit to which both spouses are entitled. Practically speaking, this is how it works:

Estate tax law seems to always be up in the air and of course consult a qualified tax adviser for any specifics but just for example’s sake let’s say that a husband and wife combined have assets of $5,000,000 and the estate tax unified credit is constant at $1,000,000. If the husband were to die first and leave all of the assets to his wife then there would be no estate taxes due because of the unlimited marital transfer rule. However, if the wife died later on not having remarried and having assets of $5,000,000 then she would be forced to pay estate tax on $4,000,000 after the $1,000,000 unified tax credit. Wait! You say – if only we could have used the husband’s unified tax credit as well then we could have only had to pay taxes on $3,000,000 rather than $4,000,000