Knowing that your loved ones will be financially secure when you are gone can be reassuring, and it is a major priority for many. According to a new ReliableInsurance study, leaving an inheritance was the most popular reason for purchasing life insurance among millennials (aged 26 to 41).
A life insurance policy might be an excellent method to leave money for your heirs. The death benefit of a life insurance policy is usually tax-free and paid straight to the beneficiaries. However, the major goal of life insurance is to alleviate the financial burden that your death would impose on others, rather than simply increasing the wealth of your beneficiaries. So, if others rely on you financially, consider purchasing life insurance to replace your income first.
How does a life insurance payout work?
When purchasing a life insurance policy, you select the amount of coverage you want. In most circumstances, the face value of your life insurance is the amount of money that your beneficiaries will get if you die. This payout is referred to as the “death benefit.” Your life insurance beneficiaries can typically select whether to receive the payoff in one big sum or in installments.
What type of life insurance should you use as an inheritance?
There are two forms of life insurance: term life and permanent life. Term life insurance is for a specific number of years, such as 10, 20, or 30, but permanent life insurance can last your entire life.
If you want a long-term policy that might last your entire life, look into permanent coverage like whole life insurance. Consider term life insurance if you require temporary coverage while building your money.
There are advantages and disadvantages to both techniques. Term life is much less expensive than permanent life, but if you outlive the policy, your beneficiaries will not get a payout. Permanent plans normally last a lifetime, but larger policies can be costly.
If you’re just seeking cheap life insurance, a term policy is likely to be a better option.
Benefits of using life insurance as an inheritance
The payout goes directly to your beneficiaries
In most cases, the death benefit is paid to the person or entity named as the policy’s beneficiary, rather than your estate. This means that the funds do not have to go through probate or pay off any existing obligations before being distributed to your beneficiaries. In short, your beneficiaries will receive the payout regardless of how your estate is handled.
Important: If no beneficiaries are designated on the policy, or if all of the beneficiaries are deceased when you die, the payout will normally be included in your estate. To avoid this, ensure that the beneficiaries mentioned on the policy are correct and current. It is also prudent to name a contingent beneficiary. This person or entity receives the payoff if the primary beneficiary dies before the policyholder.
Even if the payout is made directly to a beneficiary, the assets remain part of your estate for tax reasons if you own the policy. The federal estate tax exemption amount is $12.06 million for 2022 and $12.92 million for 2023.
The death benefit is tax-free
In general, life insurance is not taxable, thus your beneficiaries are not required to pay income taxes on the proceeds.
Beneficiaries may be required to pay taxes on any interest generated on the principal amount. This usually happens when the beneficiary receives the compensation in installments. The principal amount can earn interest while being kept by the insurer. Beneficiaries must pay taxes on the interest but not the principal.
If you live in a state that imposes an inheritance tax (Iowa, Kentucky, Maryland, Nebraska, New Jersey, or Pennsylvania), your heirs may be compelled to pay taxes on the money they get from your estate. However, a life insurance policy is normally deemed independent from your estate and is not liable to this tax.
Your beneficiaries can use the payout for any purpose
Life insurance is a means to bequeath money with no ties attached. That means, your beneficiaries may spend the funds for whatever reason. This is not true for some types of coverage, such as credit life insurance, which is often used to pay off debt.
Things to consider before buying a policy
Life insurance prices are determined by your health and age, so if you are older or have a pre-existing ailment, the cost of coverage may exceed your budget. According to Quotacy, an insurance brokerage service, the average yearly premium for a $500,000 whole life policy for a 60-year-old male is $17,735. If you cannot afford the premiums or are denied coverage, you may want to look into other strategies to generate wealth. Speak with a fee-only advisor about your alternatives.
Leaving an inheritance is not the sole reason to buy life insurance. Here are some more typical reasons to get a policy.
- Using life insurance to replace income
- Using burial insurance to cover final expenses
- Purchasing life insurance as an investment
- Using life insurance to repay debt
