Many find peace in ensuring their loved ones’ financial security posthumously, a top concern for many, particularly millennials aged 26-41, as highlighted in a recent NerdWallet study. Life insurance serves as a vehicle to transfer wealth to heirs efficiently, with the death benefit usually tax-free and directly allocated to beneficiaries.
However, its core function remains to ease the financial strain your absence could impose on dependents rather than solely augmenting beneficiaries’ wealth. Therefore, if others rely on your financial support, prioritize life insurance as income replacement.
How does a life insurance payout work?
When you purchase a life insurance policy, select the desired coverage amount. Typically, the face value of your policy represents the sum your beneficiaries receive upon your death, known as the “death benefit.” Beneficiaries can usually receive this payout as a lump sum or in installments.
Nerdy Tip: While you can hold multiple life insurance policies, insurers typically limit the total coverage amount you can obtain, usually ranging from 20 to 30 times your annual income.
What type of life insurance should you use as an inheritance?
When choosing life insurance for inheritance purposes, consider the two main types: term life and permanent life. Term life insurance covers a specified number of years—like 10, 20, or 30—while permanent life insurance can cover your entire lifetime.
For long-term needs that extend throughout your life, permanent options such as whole life insurance are suitable. If you require coverage for a temporary period, like during wealth accumulation, term life insurance is ideal.
Each type has its advantages and drawbacks. Term life insurance is more affordable but doesn’t pay out if you outlive the policy. Permanent life insurance lasts your entire life but can be costly for more significant policies. If budget is a primary concern, opt for term life insurance for cost-effectiveness.
Benefits of using life insurance as an inheritance
The payout goes directly to your beneficiaries
Direct payment to beneficiaries: The death benefit is typically paid directly to the beneficiaries you designate on the policy, bypassing the probate process and any estate debts. This ensures that your beneficiaries receive the payout promptly and independently of estate proceedings.
Important Note: If the policy lacks named beneficiaries or if they are deceased at the time of your death, the death benefit may become part of your estate. To prevent this, ensure your policy’s beneficiaries are up-to-date and accurate. Consider naming contingent beneficiaries who will receive the payout if the primary beneficiary is no longer alive.
Tax implications: Even when the payout goes directly to beneficiaries, it is considered part of your estate for tax purposes if you are the policy owner. As of 2023, the federal estate tax exemption is $12.92 million.
The death benefit is tax-free.
Beneficiaries of life insurance generally receive a death benefit that is tax-free, meaning they do not owe income tax on the proceeds.
However, beneficiaries may need to pay taxes on any interest earned on the principal amount if they receive the payout in installments. The principal amount can accrue interest while held by the insurer, and beneficiaries are taxed on this interest, not on the principal itself.
In states that impose inheritance tax (such as Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania), heirs may be required to pay taxes on inherited money from estates. Nevertheless, life insurance policies are typically treated separately from estates and are not subject to inheritance tax.
Your beneficiaries can use the payout for any purpose
Your beneficiaries can use the payout for any purpose they choose. Unlike certain types of coverage, such as credit life insurance, which settles debts directly with lenders, life insurance provides cash without specific obligations.
Nerdy Tip: Typically, life insurance payouts cannot be issued directly to minors. To leave an inheritance for young children, consider establishing a life insurance trust and naming the trust as the beneficiary. Upon your death, the payout goes to the trust, allowing the trustee to manage the funds according to your instructions for the benefit of your children.
Things to consider before buying a policy
Factors like age and health determine life insurance premiums. If you’re older or have pre-existing conditions, the cost of coverage might exceed your budget. For instance, a 60-year-old man might pay around $17,735 annually for a $500,000 whole-life policy, as reported by Quotacy, a brokerage firm. Exploring alternative wealth-building strategies is advisable if premiums are unaffordable or coverage is denied. Consult a fee-only advisor for guidance.
In addition to leaving an inheritance, common reasons for purchasing life insurance include:
- Income replacement
- Burial expenses coverage (burial insurance)
- Investment purposes
- Debt repayment
Frequently Asked Questions
What happens to life insurance proceeds after I pass away?
Life insurance proceeds, known as the death benefit, are typically paid directly to the beneficiaries you designate on the policy. This bypasses probate and ensures your beneficiaries receive the funds promptly.
Can life insurance be used as an inheritance?
Yes, life insurance can be a strategic way to leave a financial legacy for your loved ones. The death benefit can provide beneficiaries with a lump sum payment or periodic installments to support their financial needs.
Are life insurance payouts taxable as an inheritance?
Generally, life insurance proceeds received by beneficiaries are not subject to income tax. However, any interest earned on the proceeds may be taxable if received in installments. Life insurance is typically separate from your estate and not subject to inheritance tax in most states.
What types of life insurance are suitable for leaving an inheritance?
Term and permanent life insurance (such as whole or universal life) can serve as vehicles to leave an inheritance. Term life provides coverage for a specific period, while permanent life insurance covers you for your lifetime and often includes a cash value component.
Should I name a trust as the beneficiary of my life insurance policy?
Naming a trust as the beneficiary can provide control over how the proceeds are distributed, especially if your beneficiaries are minors or if you want to specify how the funds are used. Consult an estate planning attorney to determine if this approach aligns with your goals.
Can I change the beneficiaries on my life insurance policy?
You can change the beneficiaries anytime by updating the policy with your insurer. Keeping your beneficiary designations current is essential so that the proceeds go to the intended recipients.
Is life insurance a good investment for leaving an inheritance?
Life insurance can be a valuable tool for inheritance planning because it can provide a tax-free lump sum payment to beneficiaries. However, whether it is a good investment depends on your financial goals and needs. Consider consulting an economic advisor to explore other investment options as well.
Conclusion
Using life insurance to leave an inheritance offers a straightforward and tax-efficient method to provide financial security for your loved ones after you’re gone. By designating beneficiaries, you ensure that the death benefit bypasses probate and reaches them promptly.
Whether through a lump sum or periodic payments, life insurance can cater to various financial needs, from income replacement to covering final expenses or even serving as an investment vehicle. Consulting with a financial advisor can help you tailor a life insurance strategy that aligns with your specific goals and ensures your legacy is managed according to your wishes.