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Over the next 25 years, it's estimated that U.S. households will pass more than $68 trillion in wealth to their younger family members and charities.1
If you're planning an inheritance for your family, life insurance potentially could be a way to leave more behind while also covering some of your own financial needs. Here's a look at generational wealth transfer and the role life insurance can play in your inheritance planning.
The Landscape for the Great Wealth Transfer
When you're preparing to leave behind an inheritance, chances are you want as much money as possible to end up with your family. However, without proper planning, a sizable amount could go toward taxes and other expenses.
First, there are the standard expenses families end up owing after a loved one passes away: medical bills and outstanding debt, final expenses for a funeral, legal costs to process a will and distribute the inheritance, etc. Relatives usually cover these costs out of the deceased's property. Only what's left over can be the inheritance.
Depending on your net worth, your beneficiaries may also need to cover estate and inheritance taxes. The federal estate tax limit is currently very high. You won't owe unless you're worth more than $13.61 million in 2024.2 However, some states tax estates worth as little as $1 million.
Keep in mind that the tax landscape for the great wealth transfer could change soon. The current estate tax exemption is set to expire after 2025. Congress must pass a new law before then to extend it. President Joe Biden has also expressed interest in raising taxes, including those on the transfer of property at death.
These taxes and other expenses could put your beneficiaries in a tough position upon your death. If you're leaving behind noncash property such as real estate, a small business or stocks, your family may be forced to sell even when the timing isn't ideal simply to cover the inheritance bills.
Life Insurance as an Inheritance Tool
Life insurance can be a way to help provide your family with a more effective inheritance. A life insurance policy provides a death benefit, and you pick the beneficiaries who will receive the money. When you pass away, the policy pays your beneficiaries cash for the other expenses. You could also donate part of the life insurance proceeds to charity.
Leaving cash behind accomplishes the same purpose. However, if you used that money to buy life insurance, it could increase the amount you leave behind by roughly two to four times what you paid in.1
As an added benefit, life insurance death benefits generally don't go through probate, the legal process to review a will and distribute assets. Since probate can take a few months and sometimes longer, your beneficiaries may need cash to pay for expenses during this time (such as covering the bills for a house they will eventually inherit). Life insurance could provide that cash.
Another advantage of life insurance in terms of a generational wealth transfer is that policies can be easy to divide. Or you could use it to address any unequal parts of an inheritance. For example, if only one child wants to inherit the family business, you could leave your life insurance to the other.
Benefits & Drawbacks to Consider
Life insurance can provide living benefits for you too. Certain policies can help cover your medical bills or long-term care expenses. Some policies also build cash value, which grows over time and may be available to you while you're alive.
It's important to understand that accessing your cash value could lead to you owing taxes and loan interest. It could also reduce the account value and the death benefit, and may cause the policy to lapse. Still, it gives you some access to your money after buying life insurance. A customer should always determine whether a withdrawal or a loan is preferable for their individual situation.
Using life insurance as an inheritance strategy does have potential drawbacks. When you buy a policy, you'll have to pay premiums, which means spending down some of your liquid cash. Accordingly, life insurance is generally used for assets you're sure you're leaving as an inheritance. A policy can also be used as a supplement to your retirement income, but it shouldn't be viewed as a standalone retirement plan or savings plan.
Another potential downside is that you may need to undergo medical underwriting to qualify for life insurance. If you have serious health issues, this strategy might not be a viable option.
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4 Life Insurance Inheritance Strategies
As you can see, the options abound for purchasing a life insurance policy with the intention of transferring wealth to younger generations. When considering your individual needs and desires, there are a few important actions to take. Here are four strategies that can potentially help set you up for success.
1. Understand the Tax Rules for Cash Value
If your life insurance policy has cash value, you can withdraw up to what you paid in premiums generally tax-free. The IRS taxes any withdrawals over this amount as income. However, if you pay too much in premiums during the early years, according to formulas from the IRS, the policy turns into an Modified Endowment Contract (MEC).
Your insurer can tell you when you sign up whether you're creating a MEC. Single-premium policies are generally always MECs. If maintaining access to your cash value while alive is a priority, work with your insurer to design a policy that would allow it.
2. Discuss Your Plan With Other Family Members
Your decisions for life insurance and generational wealth transfer will influence the long-term finances of your family members. Accordingly, they could be interested in maximizing this future benefit for themselves. For example, they may offer to pay part of the premium so you could afford a larger policy.
And if you're worried about not being able to afford the premium years down the road, you could reach an agreement with your family that they would help. After all, they would want to keep that policy going for their future inheritance purposes.
3. Set Up a Trust Fund for Younger Family Members
If you want to leave an inheritance to a minor or a young adult, whether they could properly handle a windfall may concern you. You generally can't leave the money to a young person until they reach the age of majority in your state (usually 18 but sometimes 21).
In these situations, you can set up a trust fund on their behalf. This is a legal entity designed to hold money and property for the benefit of someone else. You could then make the trust the beneficiary of your life insurance policy. You would give the trust instructions for when it would pay out, such as at age 25.
4. Donate Your Policy to Charity
If you want to support your favorite charity, you could name it as the beneficiary of your life insurance policy. Rather than making donations each year, you could pay for a policy with a much larger future payout. Naming the charity as the beneficiary isn't irrevocable; you could still change your mind later and name a family member. In that case, though, you wouldn't receive a tax deduction for your payments.
Another option is to make the charity the owner of your life insurance policy. You'll likely get an immediate tax deduction for giving away the policy, and you may be able to deduct any future premium payments. The potential downside is that you generally can't reverse this decision.
Start Planning as Soon as Possible
Most life insurance coverage requires health qualification. The younger you are, the better your chances of qualifying. It's also easier to qualify before developing serious health conditions. If you have health issues, you may still qualify. It's free to apply and find out. Some policies, such as second-to-die policies, have more liberal medical standards too. The sooner you try, the more options you might have.
If you're weighing any of these inheritance strategies, consider starting your planning soon so you can apply with the highest chances of qualifying. A financial professional can help you understand your needs and available options. By taking advantage of these life insurance strategies, you can help your family better secure their fair share of the great wealth transfer.
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Sources
- 3 Ways Insurers Can Capitalize on the Generational Wealth Transfer. https://www.equifax.com/business/blog/-/insight/article/3-ways-insurers-can-capitalize-on-the-generational-wealth-transfer-1/.
- Estate tax. https://www.irs.gov/businesses/small-businesses-self-employed/estate-tax.
- Pros and cons of guaranteed issue life insurance. https://www.forbes.com/advisor/life-insurance/guaranteed-life-insurance/.
