How Do Insurance Policies Play an Important Role as Part of an Estate?

Insurance policies play an important role to be a part of an estate when they are used for estate planning. Because an insurance policy pays out a tax-free lump sum, beneficiaries can use the funds to cover costs and reduce hardship.

In this article, we look out how life insurance policies are able to accomplish this and how they are used for estate planning, as well as how you can determine the right amount of coverage.

How Life Insurance Policies Operate

A life insurance policy is an agreement between the insurance company and the policyholder, regardless of whether the policyholder is the insured, the beneficiary, or another party.

The policyholder agrees to pay premiums set by the life insurance company, and, in turn, the life insurance company will pay out a death benefit upon the death of the insured.

There are other aspects to be considered, including the term of the policy, its flexibility, and any cash value capabilities.

The Types of Life Insurance Policies

There are two major types of life insurance policies that you can purchase.

A term insurance policy is an attractive choice for anyone seeking a certain amount of coverage at a lower rate. Term life policies can be as much as 5 times cheaper than a whole life policy with the same amount of coverage.

These policies do expire, so the coverage that you have only lasts until the end of the term (or as long as you keep up on premiums). There is no cash value to the policy, and you do not recoup any of your premiums if you cancel it.

Permanent life insurance policies, such as whole or universal, do not have an expiration date. Both of these options provide coverage for as long as you keep up on premiums.

Permanent policies also feature a cash value aspect that you can tap into for loans or eventually transfer to the beneficiary. This portion of the policy can be invested, and you can even opt to participate in the company and receive annual dividends.

Life Insurance and Taxation

The premiums that are paid into a life insurance policy, even if they are done in a corporate setting, are not tax-deductible. Because of this, and a few other details, the eventual payout of the policy to a beneficiary is not tax-deductible.

There are instances when taxation may occur, but they are uncommon. If the life insurance policy ends up being paid to the estate instead of a beneficiary then the amount is subject to tax.

Beneficiaries can also be taxed on the interest earned on policies, but they will not be taxed on the core value of the policy.

The Uses of Life Insurance Policies for Estate Planning

While life insurance policies are not the only approach you should take to be a part of an estate plan, their large tax-free payout can be useful.

The most common uses of life insurance policies for estate planning include:

Creating wealth for beneficiaries
Preserving the estate
Maximizing the estate

While Canada does not have a specific estate tax, there are plenty of fees involved with estate processing and death. A life insurance policy can provide relief during an already tumultuous time.

Creation of Wealth

One of the most obvious reasons to purchase a life insurance policy is so that the beneficiary has access to a large sum of cash upon the death of the insured. These funds can be used for funeral expenses, but they can also be used to:

Replace the lost income of the insured
Cover costs for future life events, like university tuition
Offset increased expenses for childcare or housekeeping
Allow the beneficiary to take extra time off work after the death of the insured

Life insurance policies ensure that the beneficiary will receive funds in a timely manner, and this creation of wealth can be beneficial in both the short and long term.

Preservation of the Estate

When the executor is handling the estate they are required to do a few things before they can start to distribute the assets.

The estate is subject to taxes based on the deemed disposition of the assets. Depending on the size of the estate and the assets involved, the executor may need to find a way to cover these costs.

If an estate involves assets such as a cottage or business then one option is to sell these non-essential assets and use those funds to cover the taxes on the estate.

Another option is to use the proceeds from a life insurance policy to cover these fees so that the assets can remain in the estate for distribution to the heir.

Maximization of the Estate

With the help of a life insurance policy, the executor can offset costs so that the value of the estate remains intact for distribution. Costs that can diminish the estate include:

Probate fees (depending on your location)
Income tax
Executor’s fees
Valuator and appraiser fees
Legal and accounting fees

If part of the estate exists in another country, such as the United States, the executor will also need to handle any fees owed to that government’s legal revenue body.

The proceeds from a life insurance policy can cover all of these and more to ensure the estate maintains its maximum value.

How Much Life Insurance is Enough to Play an Important Role?

There is no set number on how much life insurance is necessary to play an important role as part of an estate. In short, the policy should be sufficient to cover:

Estate fees
Funeral and burial fees
Debt of the deceased
Income lost (if others relied on it)

You should also consider the type of life insurance when planning ahead. A term policy may not be sufficient to cover the entire estate, but it can be useful in covering set debt without increasing your premiums.

Meeting with a trained life insurance advisor like Sim Gakhar can help you determine the amount and type of life insurance needed to play a role in your estate.