If you’ve ever been to a communication or relationship workshop, you’ve probably seen the skit It’s Not About The Nail. I can’t think of a better way to illustrate how even a basic misunderstanding of something can affect us on so many levels. We’ve all laughed painfully, knowing how ridiculous yet true the interaction portrayed there is. While God gives us so much grace to get through these situations, we can still take steps to improve our ability and knowledge to understand difficult concepts or situations.
If you’ll oblige me, I’ll go ahead and make the leap from relationships to insurance. Life insurance is one of the most misunderstood products in the financial industry. If used correctly, it can be a very useful tool, especially in the realm of estate planning. However, if used incorrectly, it can cause misunderstanding and be more of a burden than a help.
In this post, we’ll discuss how life insurance can be used as a part of a solid estate plan to ensure your last wishes are carried out as efficiently and effectively.
1. Blended Families
Now more than ever, we are seeing more blended families in our everyday society. For various reasons, financial and estate planning can create complexities that aren’t solved by traditional beneficiary designations. Whether you have kids from multiple marriages, stepchildren, or a complicated extended family, life insurance can aid in a few different ways:
- It provides a set dollar amount to be given to one or multiple individuals. This is opposed to an investment or brokerage account that may fluctuate and can be hard to determine value when it is passed down. In estate planning, life insurance allows an investor to designate an intentional amount that they wish to pass to one or multiple individuals.
An example of this is an investor who is married to his second wife but has kids from his first marriage. If he is still working, he may decide to leave a life insurance policy to his wife that would support her until her retirement if he were to pass away. He can then leave any other assets such as 401ks, IRAs, or brokerage accounts to his kids that would continue to grow. In this way, there is an intentional purpose for each portion of his estate.
- It’s received tax-free. In the case of a blended family, this can allow an investor to leave a sum of money to heirs with a greater after-tax value than tax-deferred assets. Taking the example above, if an investor has adult kids and is now retired, he might be better off leaving life insurance to his kids, as inherited IRAs can trigger Required Minimum Distributions(RMDs) that can be taxed heavily if they are earning income and in a higher tax bracket. If his second wife is retired as well, she can inherit his IRA and treat it as her own, which won’t trigger RMDs until she is 73 or 75, under current law. If she is retired, her income is most likely lower also, which means she would pay less in taxes if she withdraws from her IRA.
- It can be a method to prevent contestation of an investor’s final wishes. We live in an extremely litigious society, and it’s easy for someone to garnish wrong intentions when they might have an opportunity to get some extra money. In the case of blended families, this can happen if a bad relationship with a distant family member turns into a quest to prove they are entitled to a portion of the investor’s estate. Life insurance can help to mitigate this risk as it allows someone to intentionally leave behind a certain dollar amount, which can help to prove that the amount left via life insurance is all they are entitled to, and nothing more.
As always, if you are concerned with potential estate contestation, make sure to consult with a qualified estate attorney to verify you have the right legal documents in place.
2. Illiquid Estate
With the rise of alternative investments, there can be cases in planning where a beneficiary doesn’t have any available cash to pay for final estate expenses. This can create a burden on the estate if it must take on debt or sell investments at a bad time to generate the cash to cover these expenses.
A particularly common case for using life insurance in illiquid estate planning is with real estate investors. If an investor has a lot of money tied up in real estate, this can create a large burden for the executor to manage. In addition, if the executor is a family member of the deceased investor, they are most likely still dealing with the emotional grief of a loved one passing away. The extra pressure and stress of having to deal with the financial responsibility of selling off the assets of a recently deceased loved one is not a chore many of us want to pass on to our heirs.
Because life insurance provides immediate, tax-free liquidity, real estate investors can leverage this to provide their estate with the cash it needs to fund its obligations. This is especially useful if an investor doesn’t want to invest in liquid investments such as the stock market. In this way, they can keep their assets invested in real estate while still making it easy for their heirs to fulfill their responsibilities as executors of the estate.
3. Small Business Buy/Sell
Small businesses are the lifeblood of the American economy, and not many assets hold more financial and emotional weight than a closely held family business. Whether the business has 1 or 100 employees, personal estate planning for a business owner will inevitably involve the business. Buy/Sell agreements are an important part of a personal and business estate plan to ensure all of the owners of the business are treated fairly and equitably.
Since many business owners often have the majority of their wealth tied up in their business, estate plans become an issue for their heirs, especially if the business has multiple partners or stakeholders. For surviving spouses or children, life insurance is often the best way to buy out the partner who passes away and make his or her heirs whole.
Cross-Purchase Agreement
The first way to structure a buy/sell agreement in a small business is with a cross-purchase agreement. A cross-purchase agreement is when each of the partners buys a life insurance policy on each of the other partners in the amount of their share of the company. When one of the partners dies, the policy proceeds to go to the deceased partner’s beneficiary to buy out their inherited share. A cross-purchase agreement typically works best with a small number of owners, typically 5 or less. If there are many owners, the number of policies needed increases exponentially.
The formula to calculate the number of policies needed is n=p(p-1). For example, if there are 10 partners, the number of policies needed would be n = 10(10-1). This would equal 90 total policies.
Buy/Sell Agreement
The second way to structure a buy/sell agreement with a deceased partner is with an entity purchase agreement. In an entity purchase agreement, the business itself purchases a life insurance policy on each of the owners equal to their share of the company. The business then pays the premiums to keep the policies active. This agreement typically works better when there are more partners or stakeholders involved, as there is only one policy needed per partner.
Because of the other complexities involved with businesses and valuations, it’s always a good idea to bring in the expertise of a qualified business and/or estate attorney to help with these kinds of estate planning situations.
4. Charitable Giving
The final strategy for life insurance and estate planning is when charitable giving is involved. Charitable giving can provide many tax benefits, both in estate tax and income tax. In this case, there are two main factors to consider when deciding to use life insurance in an estate plan that includes charitable giving. They are as follows:
- The investor wants to give to both charities and individuals.
- The investor has primarily tax-deferred money.
To evaluate if life insurance is right for an estate plan including charitable giving, the intention is the first and primary consideration. When giving any asset, it’s important to note that there will never be more money left at the end of the gift. The asset is leaving the hands of the investor, so their overall net worth will decrease. This seems obvious, but it is important to make this point—if the investor needs the money for their expenses or desires, holding onto it will result in a higher value for themselves personally. However, if the investor does not need the money and wants to give charitably, there are valuable tax benefits that can result.
The second factor to consider in using life insurance in charitable giving is the type of account that the investor owns. If an investor owns primarily tax-deferred assets, such as an IRA or 401k, these assets are taxed differently to heirs. For example, if an investor passes down an IRA to an adult child, most of the distributions will be taxable to the heir. However, if an investor passes down the IRA to a qualified charity, the charity will not pay tax on these assets due to their IRS status.
Given the scenario above, life insurance can be a valuable addition to this estate plan. By giving the IRA to charity and buying a life insurance policy with the child as the beneficiary, both the charity and the child receive tax-free funds once the investor dies. This results in a win-win for both sides.
Plan For Your Future with Evergreen
In the end, gaining an understanding of the role that life insurance can play in estate planning is vitally important to making informed decisions for your personal estate plan. Whether you are a small business owner, have a blended family, or are charitably inclined, increasing your knowledge of life insurance will lead to better outcomes and prevent misunderstandings along the way.
To avoid any confusion tailored to your specific church and for more in-depth information, reach out to us at Evergreen Financial Group—we’re ready to steward you in your financial journey.
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