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Knowing loved ones will be financially secure after you're gone can be a great comfort, and it’s a top priority for many. In a new study by NerdWallet, leaving an inheritance was the most selected reason to buy life insurance among millennials (ages 26-41).
A life insurance policy can be an effective way to pass money to your heirs. The death benefit goes directly to the policy’s beneficiaries and is typically tax-free. However, the primary purpose of life insurance is to relieve the financial burden your death would place on others, not to simply increase the wealth of your beneficiaries. So, if people rely on you financially, consider buying life insurance to replace your income first.
How does a life insurance payout work?
When you buy a life insurance policy, you choose the amount of coverage you want. The face value of your life insurance, also called the death benefit, is what your beneficiaries receive if you die. Your life insurance beneficiaries can often choose to receive the payout as a lump sum or in installments.
You can have more than one life insurance policy, but insurers generally place limits on how much coverage you can buy. This limit is typically 20 to 30 times your annual income. Coverage limits exist because insurers don’t want your death to be appealing to others.
What type of life insurance should you use as an inheritance?
If you want a policy to pay out regardless of when you die, consider permanent coverage such as whole life insurance. If you need temporary coverage while you build up wealth, consider term life insurance.
There are pros and cons to both approaches. Term life is considerably cheaper than permanent life, but if you outlive the policy, your beneficiaries won’t receive a payout. Permanent policies typically last your entire life, but larger policies can be pricey.
Benefits of using life insurance as an inheritance
The payout goes directly to your beneficiaries
In general, the person or entity you list as the policy’s beneficiary receives the death benefit, not your estate. This means the funds don’t have to go through probate or pay off any outstanding debts before reaching your beneficiaries. In short, your beneficiaries receive the payout regardless of how your estate is handled.
Important: If no beneficiaries are named on the policy, or if all of the beneficiaries are deceased when you die, the payout typically becomes part of your estate. To avoid this, make sure the beneficiaries listed on the policy are accurate and current.
Even if the payout goes directly to a beneficiary, the funds are still considered part of your estate for tax purposes if you own the policy. The federal estate tax limit for 2022 is $12,060,000. If all of your assets, including the death benefits from any life insurance policies you own, exceed this amount, you may be required to pay estate tax on the excess. However, due to the high limit, relatively few estates are subject to this tax.
The death benefit is tax-free
In general, life insurance is not taxable, which means your beneficiaries do not have to pay income tax on the proceeds.
Beneficiaries may have to pay tax on any interest earned on the principal amount. This typically occurs when the beneficiary receives the payout in installments. The principal amount can generate interest while it’s being held by the insurer. Beneficiaries must pay tax on this interest, but not the principal amount.
If you live in a state that levies inheritance tax (Iowa, Kentucky, Maryland, Nebraska, New Jersey and Pennsylvania), your heirs may be required to pay tax on the money they inherit from your estate. However, a life insurance policy is typically considered separate from your estate and not subject to this tax.
Your beneficiaries can use the payout for any purpose
Life insurance is a way to leave cash without strings attached. That is, your beneficiaries can use the money for any purpose. This is not the case with some types of coverage, such as credit life insurance, which typically goes to a lender to pay off debt.
In general, insurers won't issue a life insurance payout to minors. So if you’re leaving an inheritance for young children, you may want to consider setting up a life insurance trust and naming the trust as the beneficiary. When you die, the payout goes to the trust. The trustee can then issue the payout to your children according to your guidelines.
Things to consider before buying a policy
Life insurance rates are based on your health and age, so if you’re older or have a preexisting condition, the cost of coverage may not be in your budget. For example, the average annual premium for a $500,000 whole life policy for a 60-year-old man is $18,270, according to Quotacy, a brokerage firm. If you cannot afford the premiums, or are denied coverage, you may want to consider other ways to build wealth. Talk to a fee-only advisor about your options.
Leaving an inheritance isn’t the only motivation for getting life insurance. Here are other common reasons to buy a policy.