“Life insurance may play a vital role in an estate plan, because insurance proceeds can be counted on to provide liquidity when it’s needed. With proper planning, insurance money can pay expenses, such as the estate tax and keep other assets intact.”
Let’s say that Howie passes away and leaves a big estate to his daughter Eva, and there’s an equally large estate tax due. However, most of Howie’s assets are tied up in real estate and in his IRA.
With that scenario, Eva might not want to immediately force a sale of the real estate. However, if she accesses the inherited IRA to raise money, she’ll have to pay income tax on the withdrawal and lose a terrific opportunity for extended tax deferral.
FedWeek’s recent article, “Common Mistakes in Life Insurance Designations,” explains that considering this type of scenario, Howie could purchase insurance on himself.
The proceeds from Howie’s life insurance policy would then be used to pay the estate tax bill. With that taken care of, Eva could keep the real estate, while taking only minimum required distributions from the inherited IRA.
If the insurance policy is owned by Eva or by a trust, the proceeds probably will not be included in Howie’s estate and will not increase the estate tax obligation.
That’s a smart way to plan it out. However, some life insurance errors can wreak havoc with an estate plan. Let’s look at some common mistakes:
Naming your estate as beneficiary. This puts the proceeds in your estate—and the money will be exposed to estate tax and your creditors. Your executor will also have more paperwork, if your estate is the beneficiary. Instead, designate the appropriate people or charities.
Designating a single beneficiary. Always name at least two contingent or “backup” beneficiaries, which will decrease or eliminate any confusion, if the primary beneficiary predeceases you.
Filing and forgetting the policy. Review your policies every three years. If the beneficiary is an ex-spouse or someone who’s died, make the appropriate change and get a confirmation, in writing, from the insurance company.
Not having adequate coverage. If you have young children, it will take a small fortune to pay for their expenses, including college, in case of your untimely death. Be wise with enough coverage for your children and for whoever will take care of them. It may not or may not be a spouse, but children don’t raise themselves and you don’t want a bargain basement mom for your kids.
Reference: FedWeek (February 14, 2019) “Common Mistakes in Life Insurance Designations”