The role of life insurance in estate planning and wealth transfer

Life insurance has long played a crucial role in estate planning and wealth transfer. Its evolution has addressed two primary challenges: creating an estate when liquidity is insufficient to support the needs of an insured’s survivors and preserving an estate in the face of illiquidity, which may occur in large estates or business succession scenarios.

Life insurance traditionally was viewed mainly as a tool for providing death benefits. Today, it has expanded far beyond this original purpose. It is now often leveraged for its tax advantages, even when there isn’t a significant need for insurance coverage. This expanded role underscores the importance of understanding various strategies and considerations involved in using life insurance. For insurance agents and financial advisors, this represents an opportunity to offer more comprehensive planning strategies and solidify client relationships.

Simple needs, simple solutions

In the fundamental case of creating an estate, life insurance remains a staple of financial planning. This need should be calculated based on cash flow requirements and the liquidity necessary to meet survivors’ needs. Providing this essential service goes beyond typical investment management and is crucial to holistic estate and financial planning.

Estate planning decisions significantly impact life insurance benefits. Initiating these conversations ensures that insurance policy decisions align seamlessly with an individual’s overall financial picture.

Life insurance offers flexibility in estate planning that few other financial instruments can match. Policies can be adjusted over time to reflect changing circumstances such as increases in estate value, changes in tax laws or shifts in family dynamics. This adaptability allows for ongoing optimization of the estate plan. A holistic view of the client’s financial situation is crucial when selecting life insurance products. Factors to consider include the duration of coverage needed, the client’s saving and investment discipline, and their ability to fund a policy long-term. 

Immediate liquidity

A crucial aspect of estate planning is ensuring sufficient liquidity to meet various financial obligations that arise upon the death of an individual. These obligations can include estate taxes, outstanding debts, business continuation needs and providing for surviving family members. A life insurance policy held outside the estate with a death benefit sufficient to cover these obligations allows beneficiaries to inherit assets without the need to sell them hastily. 

Life insurance provides an immediate source of cash upon the death of the insured. This is particularly valuable in estates that are asset rich but cash poor. 

Adequate planning can provide for immediate loved ones and reduce family friction in the event of an unexpected death. Without a clear estate plan, disagreements over asset distributions can cause unnecessary stress. Estate planning also facilitates a smooth wealth transition to future generations, exploring options to minimize tax burdens and ensuring assets are passed according to the client’s wishes. These discussions can deepen client relationships by demonstrating the advisor’s genuine interest in their long-term well-being and legacy.

Irrevocable life insurance trusts 

ILITs are effective estate planning tools that hold life insurance policies outside the beneficiary’s taxable estate, preserving the death benefit’s full value for beneficiaries by avoiding the 40% federal tax on estates that exceed the exemption limit. 

At the end of 2025, the historically high estate tax exemption of $13.61 million (plus next year’s increase) per person and $27.22 million per married couple (plus two times next year’s increase) will return to an estimated $6 million-$8 million per person or $12 million-$16 million per couple (adjusting for inflation). This suddenly makes the estate tax an important consideration for many more households. 

Furthermore, ILITs allow trustees or settlors to control the distribution of assets to beneficiaries, such as specifying staged distributions at certain ages to encourage financial responsibility. Modern trust features, such as trust protector provisions, offer flexibility to adapt to changing circumstances. ILITs also provide asset protection from creditors, shielding the death benefit even if the beneficiary faces legal action. 

ILITs become particularly crucial in scenarios involving the simultaneous or near-simultaneous death of two individuals, such as spouses or partners, due to an accident or natural disaster. In cases where two people die at the same time or in close succession, determining the order of death can be challenging and complicate the distribution of assets. An ILIT can help bypass a complex probate process by having a clear distribution plan in place, regardless of the order of death. 

In the case of a sudden, unexpected common death, beneficiaries might be unprepared to manage a large influx of wealth. The ILIT can provide structured distributions and professional management, protecting beneficiaries from poor financial decisions or outside influences.

By using ILITs in estate planning, clients can maximize the benefits of their life insurance policies while minimizing estate taxes. Clients can not only protect assets for their beneficiaries but also structure asset distribution in a way that protects their heirs from the hazards of sudden wealth.

Business succession planning

Life insurance can also be a tool to fund buy-sell agreements for business succession planning. These agreements stipulate what happens to a business owner’s share of the company upon their death, disability or retirement. Life insurance can provide the necessary liquidity for surviving partners or the company itself to purchase the deceased owner’s share from their estate. 

The buy-sell agreement’s structure has tax implications that should be carefully evaluated based on the business entity type and number of owners. One-way buy-sell plans can facilitate tax-efficient transfers from one generation to the next.

By using life insurance to fund these agreements, business owners can ensure that funds are immediately available to execute the buyout, preventing potential conflicts or financial strain on the business or surviving owners. 

For family-owned businesses, life insurance can be an effective tool for estate equalization. One child may be active in the family business while others are not, and the business owner might want to leave the business to the active child but still treat all children equally in their estate plan. Life insurance can provide liquid assets to nonactive children, equalizing the inheritance without forcing the sale or division of the business.

Retirement income strategies

Life insurance can also supplement retirement income, offering benefits similar to a Roth IRA without the same contribution and income limits: albeit with some costs associated with the insurance premium. Properly structured cash value policies can provide tax-free income and serve as a permission slip for clients to spend down their other assets.

For ultrahigh-net-worth clients who are facing estate tax liabilities and who have not been able to successfully transfer assets out of their estate, life insurance owned by an ILIT can provide liquidity to pay estate taxes, avoiding the need for fire sales of illiquid assets. Certain trust structures can offer flexibility for indirect access to policy cash values.

Building a legacy with life insurance

Life insurance is no longer only about providing a payout after a loss. It can be a powerful tool for crafting and protecting a client’s legacy. Agents and advisors can build customized plans addressing each client’s unique goals and values, thereby establishing themselves as trusted partners in the client’s financial journey.

Embracing this forward-thinking approach allows advisors to navigate the complexities of estate planning effectively. By leveraging their knowledge and fostering open communication, advisors can empower clients to build a secure and lasting legacy for future generations.

Steve Lockshin is a founder of AdvicePeriod and Vanilla, an estate planning software firm. Contact him at [email protected].