How life insurance works with estate planning
Life insurance can play a major role in estate planning, from helping your beneficiaries cover your final expenses and estate taxes to leaving a nest egg for your children. Depending on whether you get a term or permanent life policy, you'll need to factor your life insurance into your estate planning differently.
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What is estate planning?
Estate planning is the process of arranging to distribute a person's estate at the end of life and after their death. It involves creating a plan to manage the individual's assets and ensure that their final wishes are carried out.
An estate plan might encompass the following goals:
Establishing how to distribute assets to your beneficiaries
Choosing beneficiaries and designating when and how they'll receive the assets
Naming guardians for minor children or adult dependents
Arranging for the payment of debt and liabilities
Creating wills, trusts, and powers of attorney to ensure the plan is legally binding and enforceable
Implementing strategies to minimize taxes wherever possible
Making healthcare decisions in case of incapacitation
What's the difference between an estate plan and a will?
An estate plan is the broad strategy that includes plans and legal documents for managing and distributing an individual's assets after death. The will, which is part of an estate plan, is a legal document outlining how an individual wants their assets to be distributed after death.
What's the difference between a life insurance beneficiary and a beneficiary of a will?
A life insurance beneficiary is the designated recipient of a life insurance policy's death benefit, whereas the beneficiary of a will is the designated recipient of a specific asset or assets of the deceased's estate. The process of receiving these assets also differs. Life insurance proceeds typically pay out soon after the policyholder dies, while the beneficiary of a will may wait several months before receiving the asset they're entitled to, depending on the probate process.
Steps to take when adding life insurance to your estate plan
Adding life insurance to your estate plan involves several steps to ensure that it fits your goals. Here are some steps to get started:
Assess your needs
Determine how much coverage you'll need based on your financial obligations.
Clarify your goals for the insurance policy. Do you want to provide for your family, pay estate taxes, or donate to your favorite charity?
Choose the right policy
Term life insurance offers coverage for a specific period at an affordable rate but doesn't build cash value.
Whole life insurance provides lifetime coverage and includes a cash value that grows over time.
Universal life insurance offers flexible premiums and death benefit amounts, plus a cash value component.
Choose beneficiaries
Name primary and contingent beneficiaries, and regularly review and update beneficiary designations to reflect changes in your life, such as marriage, divorce, or the birth of a child.
Integrate with your estate plan
Work with an estate planning professional to ensure the life insurance policy aligns with your overall estate plan.
Consider setting up a trust, such as an irrevocable life insurance trust (ILIT) to hold the policy and manage the proceeds, which can help reduce estate taxes and provide asset protection.
Coordinate your policy with your will and other estate planning documents.
Maintain estate plan records
Keep detailed records of your policy and beneficiary designations and inform your executor about the policy and where to find the documents.
Plan for taxes
Be aware of potential estate and income tax implications for life insurance proceeds. Consult with your financial advisor as needed.
What types of life insurance are used in estate planning?
Two types of life insurance are typically used in estate planning:
Term life insurance
Since term life insurance pays out a death benefit if you pass away during the "term" that the policy is active (usually 10 to 30 years), you might choose this option for estate planning only if you'd like a policy to support your estate until you reach a certain age. You might choose this option if you expect that payment of your final expenses, estate taxes, and any inheritance you want to leave your beneficiaries can come from another source (like savings or investments) after a certain point in your life.
Universal or whole life insurance
Permanent life insurance policies stay in effect for your entire life, no matter when you pass away, and they benefit from a cash value that builds over time. You might choose policies like whole life insurance or universal life insurance if you want to make sure your estate taxes, final expenses, and the legacy you plan to leave behind are covered by your life insurance death benefit no matter when you pass away.
When should you start using life insurance in estate planning?
Once you've acquired some assets, purchased a home, or started a family, it's time to consider life insurance in estate planning. It's generally cheaper to get life insurance when you're younger, as your health risks are usually lower. As you age, a life insurance policy will become more expensive. So, if you plan to use your life insurance to support your estate, it's best to start planning as soon as possible.
Learn more about life insurance cost factors.
Ways to use life insurance for estate planning
You can use life insurance in estate planning to help your family cover your final expenses, pay off estate taxes, and ensure an inheritance for your loved ones.
Covering final expenses
If you don't want your final expenses to burden your family when you pass away, you can plan for your life insurance death benefit to cover those costs. There are even final expense life insurance policies, but you can use any life insurance policy's payout for final expenses.
Keep in mind the following costs when calculating your final expenses:
Funeral expenses: According to the National Funeral Directors Association, the median cost of a U.S. funeral with a burial and viewing was $8,300 in 2023. For a funeral with cremation, it was $6,280. You can plan for your funeral costs and factor them into how much life insurance you should get.
Outstanding debts: If you have any debts when you pass, they may become the responsibility of your heirs. A life insurance policy can help cover these debts so they're not a burden to your family.
Final income taxes: Your heirs may have to cover any unpaid back taxes, as well as taxes due for the year in which you pass away. A death benefit can help cover these expenses.
Paying for estate taxes
Depending on the size of your estate, inheritance taxes can be significant. The death benefit of a life insurance policy is typically tax-free and can help cover any estate taxes.
Can you use life insurance to avoid estate taxes?
If the value of your estate exceeds the federal estate tax threshold, then a life insurance policy placed in a life insurance irrevocable trust (ILIT) can provide a tax-free inheritance to your beneficiaries. Otherwise, the proceeds of your life insurance policy would be included in your estate, contributing to the total estate tax owed.
Equalizing your estate
If you have multiple heirs, a life insurance payout can help equally split your assets., which can be especially useful if you have investments that are difficult to divide, like real estate or a business.
Example:You have a vacation home and two adult kids. One wants to sell the property when you pass away, and the other wants to keep it but can't afford to buy their sibling's share. You could leave the home to the child who wants it while purchasing a permanent life insurance policy with a face value equal to the home's value. The child who doesn't want the home can be the beneficiary, which allows you to leave them similar inheritances without selling your vacation home.
Fund ongoing expenses
The death benefit of a life insurance policy can go toward your loved ones' daily expenses or add to their overall inheritance. It can even help a child with special needs or an ill or aging loved one. In necessary cases, the death benefit would go into a trust managed by a trustee. Learn more about creating a life insurance trust for a minor child.
Create buy-sell agreements
If you own a business with a partner or multiple owners, life insurance combined with a buy-sell agreement can help you ensure your family is compensated fairly for your share of the business when you pass away.
A buy-sell agreement funded by life insurance policies ensures your business partners can afford to buy out your portion of the business when you pass away. Each owner purchases a life insurance policy on the other. If a partner dies, the death benefit gives the other partners the funds to buy out the deceased's share of the business.
Is life insurance a good way to leave an inheritance?
Yes. Life insurance can be an excellent way to leave an inheritance due to the many benefits it offers, including but not limited to the following:
Proceeds paid to beneficiaries tax-free
It avoids probate as beneficiaries receive life insurance proceeds outside the probate process
Avoid estate taxes when you place a life insurance policy in an irrevocable trust (if your estate exceeds the tax threshold)
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