Life insurance is a tremendously powerful tool for estate planning concerns and can solve many problems. Let's take a look
At your death, estate taxes need to be paid (if you owe estate taxes). If you are married, these may be delayed until your spouse's death. Other costs such as funeral expenses, debt settlement, and administration fees can add to the need to have cash and life insurance provide liquidity almost instantly at death. Other than cash on hand, no asset can provide such a predictable and immediate influx of dollars to pay the costs incurred or supply ther liquidity needs as can life insurance.
Perhaps, to pay estate taxes, liquidation of your investments or business may not be timely and produce a substantial loss in value. To maintain intact your investment holdings or business so you can pass them on to your children, you or your spouse may purchase life insurance as, possibly, a more economical option to having to liquidate your holdings. Why sell assets when a simpler supply of cash can be available.
If you are married, survivorship life insurance generally is used to provide liquidity for final expenses when the second one of you dies.
You can combine charitable giving with life insurance to make the donations you always wanted to and you can do this without reducing assets you want to pass on to your beneficiaries.
Here is how it works…
You can - if you have the wealth - give a substantial lifetime gift of appreciated property to a qualified charity. This gifting generates a significant tax deduction. With the income tax savings you get from this deduction, you can purchase life insurance - whose proceeds at your death will replace the wealth that you gave to charity. That is, the life insurance proceeds will go to your children (tax free)
Policy Owned Outside Your Estate
In both these examples, if you maintain ownership of the life insurance, then its death proceeds will be added to the value of your estate. This, in turn, will add to the estate tax on your estate. The simple solution is to have the policy owned by family members.
The fact that life insurance proceeds are free of income tax does not alleviate its contribution to your estate tax. You can keep the life insurance that is on you out of your estate by either giving away ownership of it - at least three years before your death - or by having some other person or legal entity purchase it and own it in the first place. In that case, the insurance proceeds may still be used for paying all those final expenses but would not add to your estate tax. Trusts are common legal entities for purchasing and owning life insurance in such circumstance.
Say you have two sons. One is interested in taking over the family restaurant worth $1.5 million and the other son has no interest. In your estate plans, you leave the restaurant to the first son. Do you just leave the other son nothing? Simple solution--buy a life insurance policy for $1.5 million that pays off to the second son thereby leaving both children the same value of assets.