Six ways to use life insurance in wealth planning
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Wealth management is a deceptively big idea: It's about creating and implementing a comprehensive strategy to grow and protect wealth and family assets throughout your lifetime. Wealth planning tends to focus on the optimal management of your investment portfolio and sophisticated tax planning that will benefit yourself and your family over time. And assuming you want to pass on assets to your heirs, family wealth planning can and should extend to estate planning. But if it's just about your investments: incorporating life insurance in wealth planning may also make sense — particularly permanent policies that have a cash value component.1
What types of life insurance can be used in wealth planning?
The primary purpose of any life insurance policy is to provide financial protection for your loved ones if you unexpectedly pass away. It provides a lump-sum death benefit that is paid out free of income tax, and depending on the size of the policy, that lump sum can be enough to replace several years of salary that you would have otherwise been able to provide.2
Life insurance policies can also play a role in building lifetime wealth, but some types of policies can take a more active part of your wealth planning strategy than others.
The two basic types of life insurance
Term life insurance provides a death benefit for a limited period of time, for example, 10 or 20 years.
Permanent life insurance3 - whole life insurance and universal life insurance4 is designed to provide life-long coverage while also building cash value: A portion of your monthly premiums is set aside in a cash account, where funds grow tax-efficiently over time. However, this cash value can also be tapped into or borrowed against, so permanent life insurance can help build family wealth while you’re still alive.5
The strategies discussed below rely on these types of permanent, cash-value policies. However, even term life policies that don’t build cash value can be useful for wealth planning: The confidence of a substantial income tax-free death benefit payout can allow you to invest more — and in potentially illiquid assets like real estate — rather than keeping a large cash cushion to provide for your family in case of unexpected death.
Strategies for using life insurance in wealth planning
Here are some specific suggestions for strategies that can be used as part of your wealth planning process. But remember, no strategy is right for every person or situation, so be sure to consult with a trusted financial or tax professional to optimize the tax benefits of these strategies.6
1. Use life insurance to pay estate taxes
Many households have substantial illiquid assets, like real estate or business holdings. If you’re among them, and expect to be subject to estate tax, having a substantial life insurance policy can help eliminate the need to sell assets to cover estate tax liability.
If the estate you leave to your heirs is large enough to trigger the estate tax, your estate — not your beneficiaries — may owe taxes that must be paid before assets can be distributed. When the death benefit payout from a permanent life insurance policy can be used to cover these taxes, assets can be passed on more easily without having to free up cash or liquid assets intended for other purposes. But if you're planning to use life insurance in this way, you shouldn't rely on a term life policy: if the policy term ends before you pass away, there's no value left, and no payout to cover estate taxes.
2. Borrow against your life insurance policy
Utilizing debt to your advantage is a common part of wealth planning — and your life insurance policy can be an source of loans. Once you have substantial value built up in your cash value plan, you can start taking loans against it. This process is somewhat similar to a 401(k) loan in that you're essentially borrowing from yourself and repaying your own investment account over time. However, policy loans can provide even more flexibility because they don't necessarily have to be repaid, although any outstanding loan balances will be deducted from the death benefit payout.
3. Use life insurance in your charitable giving strategy
Your life insurance policy can also be utilized to benefit causes you are passionate about. There are a number of ways to do this:
Donate your policy to a charity. They can surrender it immediately for its cash value or hold it for the eventual policy payout after you pass away.
If you have a whole life policy from a mutual company (like Guardian) it may pay annual dividends depending on the company’s financial performance. You can donate those policy dividends to charity each year.7
A life insurance policy can have multiple beneficiaries so that you can name one or more charities as policy beneficiaries.
Guardian offers a charitable benefit rider on our level term that will send 1% of the policies face amount to the charitable organization of your choice. This option is also only available on GLT, not all of Guardians products.
These strategies may also help you preserve wealth by allowing you to allocate more funds toward current investments. For example, instead of donating a fixed sum to charity each year, you can invest those funds and use your life insurance benefit to make a sizable gift to the cause you choose after passing away.
4. Use cash value to fund education
You may also choose to use cash value life insurance as a funding source for your children’s education. While tax-efficient education funds like 529 are a popular choice, these require setting aside separate funds to begin saving. By utilizing the cash value life insurance, you can tap into funds you have already built up. This can help free up more cash for retirement planning investments. Or, if you’re an empty nester who has already retired you can use cash value to help fund college for your grandchildren — especially since you may not need the full death benefit amount anymore.
5. Protect your business using life insurance
If you’re a business owner, there are several ways to utilize life insurance to your advantage:
Key employee policies can protect your firm with a financial cushion in the event that a crucial employee unexpectedly passes away.
Split-dollar life insurance agreements can be used as an attractive incentive to recruit and retain high-level employees.
If you co-own your business with one or more partners, life insurance policies can be used to fund buy-sell agreements to help ensure business continuity in the event that a partner passes away unexpectedly.
Life insurance can also be used a funding vehicle for qualified retirement plans, which can provide certain tax advantages and help fund pre-retirement death benefits.
It’s important to note that these are all sophisticated ways to use life insurance, so you should consult with your business’ tax and financial professional to determine their suitability for your individual circumstances.
6. Use life insurance to equalize estate distributions among your heirs
If you have illiquid assets such as real estate or business holdings, evenly distributing your assets among multiple heirs can be complex. Life insurance can help provide the missing piece of the puzzle that helps you figure out a fair distribution.
We’ll use a very simple scenario to illustrate: You have a single valuable asset — your primary residence — but have two heirs (your two children), one of whom lives in the house. How can you leave equal shares of your estate to each child without selling the house that one lives in? Life insurance proceeds, paid out free of income taxes, can be an efficient way to compensate the other child and help ensure each gets a fair share.
How to start using life insurance for wealth and estate planning
As noted, a permanent life insurance policy may give you the most flexibility for wealth planning because it can provide life-long protection — even if you live past 100 — while building cash value that enhances family assets.8
Of course, buying life insurance is one thing, but ensuring that such a policy remains in effect and all premiums are current is also important. This will protect your policy from lapsing, help keep the death benefit intact, and allow your cash value to continue to grow.
There are also a number of issues that you should discuss with your tax and financial professionals as part of your wealth and estate planning process. Ask whether it makes sense to set up a trust, and if so, what kind. There may also be certain tax efficiencies to holding your life insurance policy inside a trust.
Consider how you want to leave a legacy — and how to use life insurance as part of your estate plan to reflect your wishes. Perhaps you want to donate a substantial sum to charity or nonprofit; as we've noted, you want to name that organization as a beneficiary or donate your life insurance policy altogether. Or, looking at the overall picture, it may make more sense to use life insurance to balance the distribution of assets in your will or to cover estate taxes after you pass away.
This estate planning checklist can be a good place to start building your estate plan. But the more assets you have, the more choices there are to make and the greater the complexity. So however you start, it’s best to work with qualified professionals to finalize your comprehensive estate plan.