How to use life insurance to leave an inheritance

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.

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.

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.

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^[0]

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.

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.