How is life insurance used in estate planning?

As you go through the estate planning process, you may find that at some point the conversation veers off into a discussion about life insurance. This is because life insurance can fill a lot of gaps in a person's estate by creating new wealth that can be used in a dozen ways.

When you buy a life insurance policy, you are asked to name a beneficiary who will receive the proceeds of the policy when you pass away. Sometimes the buyer will name his or her estate as the beneficiary, usually because he or she wants to achieve a particular estate-planning goal.  For example, life insurance money that is paid into an estate can be used to pay the general debts and expenses of the estate such as the funeral, legal fees and liabilities such as loans.

When an estate has a significant tax liability, life insurance can be very important. For example, the capital gains tax hit on a cottage can be quite large. Having insurance money available to pay the tax can mean the difference between being able to pass the cottage on to the kids and having to sell it.

Life insurance money can be used to pay a gift to a child of the deceased when another of the deceased's children is going to get the main assets of the estate. This would apply, in particular, where one child is going to get the deceased's business, farm or cottage. The child who is not going to get that asset can receive life insurance money instead.

Parents of minor children can hold life insurance funds in a trust for their children through their Wills, to supplement any other assets the children might be inheriting. This would create a larger inheritance for the children, which might be important if the trust has to help support a child for years before he or she reaches adulthood.

The above examples all involve naming the estate as the beneficiary. Other beneficiaries may be named, such as the children directly, or the policy owner's spouse. Many married couples will name each other as the beneficiaries of their policies so that no matter what happens to the estate, such as being held up for years in litigation, there is still money being paid directly to the spouse.

Life insurance policies also come into play for owners of incorporated businesses where they are not the only shareholder. Ideally, the owners create a shareholders' agreement, or buy/sell agreement in which they decide how shares of one of them will be dealt with if one of them passes away. Typically the agreement will state that the company will buy back the deceased's shares from the estate. In order to have cash flow available, the company buys an insurance policy on the life of each shareholder, and designates the company as the beneficiary. Then when the person passes away, the life insurance flows to the company, which then uses the money to buy the shares from the estate, leaving the estate with money for the beneficiaries.

Life insurance, though widely used, is not necessarily for everyone. However, it should be part of the discussion if the discussion is about expenses or taxes.