Life insurance in estate planning: paying the tax, equalising the heirs, and keeping the proceeds outside the estate
Cover is the cheapest liquidity an estate can buy, and the most commonly misplaced. The three jobs it does, who should own the policy in each country, and a worked example of equalising the child who gets the business.
General information, not advice.
Key facts
Life cover in an estate plan does three jobs: it pays the tax or debt so nothing has to be sold in a hurry, it equalises heirs when one asset cannot be split, and it replaces the income a dependant loses.
Who owns the policy decides whether the payout is taxed, whether it passes through probate, and whether creditors can reach it. In the US a policy the deceased owned or controlled is in the taxable estate; in the UK a policy not written in trust is counted for inheritance tax at 40%; in Australia cover inside superannuation is tax-free to a dependant and taxed at 17% on the taxable component to an adult child.
Cover bought in the last twenty years of life is expensive and underwritten hard; the plan that relies on it should be made in the fifties, not the seventies.
The three jobs
Liquidity. An estate with a house, a business and a farm has assets and no cash, and the tax office, the lender and the funeral director want cash. Cover pays them so the executor is not selling the business to the first bidder in the month after the death. In the United Kingdom the tax must be paid before probate is granted; in the United States the estate tax return and payment are due nine months after death; in Canada the final return is due the following April. Equalisation. One child runs the company and should inherit it; the other two should not be left with nothing, and the company cannot be cut in three. Cover on the parent's life, payable to the two, makes the shares fair without dismembering the asset. Replacement. A dependant spouse, a child with a disability, a parent supported monthly: cover replaces what the death stops, and a policy paid into a special-needs or disability trust does it without disqualifying the child from public support.
Who owns the policy, by country
Country | Where the payout lands by default | How to keep it where you want it |
|---|---|---|
United States | In the taxable estate if the deceased owned the policy or held any incident of ownership; income-tax free to the beneficiary either way | An irrevocable life insurance trust (ILIT) owns the policy from the outset; a policy transferred into it within three years of death is pulled back into the estate under section 2035; the trust pays premiums from annual-exclusion gifts with Crummey notices |
United Kingdom | Counted for inheritance tax at 40% unless written in trust; delayed by probate | Write the policy in trust from the outset (most insurers' trust forms are free): outside the estate, paid in weeks, not months, and usable to pay the tax on everything else; a policy paid to a spouse is exempt anyway |
Australia | Outside the estate if paid to a nominated beneficiary; inside super, taxed by recipient: tax-free to dependants, the taxable component at 17% to adult children, with the untaxed element from the fund's premium deductions taxed at 32% | Cover held outside super for adult-child beneficiaries; a binding non-lapsing nomination inside super for a spouse; a testamentary trust through the estate when control matters; a policy owned by the child on the parent's life for equalisation |
Canada | Tax-free to a named beneficiary and outside probate and the estate's creditors; through the estate, probate and the creditors if none is named | Name the beneficiary or a trust; corporate-owned policies credit the capital dividend account so the proceeds can be paid out tax-free; a policy owned by the holding company avoids the personal estate |
Israel | Paid to the named beneficiaries outside the estate; no inheritance tax; the will does not override the nomination unless the insurer was told | Keep the nomination current, particularly after a divorce; a "pension-track" policy pays an annuity under the fund's rules |
Singapore | Paid to nominees outside the estate under a trust nomination (section 73 of the Conveyancing and Law of Property Act, irrevocable, for a spouse or children) or a revocable nomination under the Insurance Act | Trust nomination for a spouse or children is creditor-protected and cannot be changed without their consent; a revocable nomination for anyone else; without either, the policy passes under the will and through the grant |
EU (DE, FR, ES) | Generally outside the succession and paid to the named beneficiary, with inheritance tax treatment varying: France's assurance-vie has its own regime (€152,500 per beneficiary tax-free for premiums paid before seventy, then 20% and 31.25%; €30,500 for premiums after seventy); Germany taxes the payout as a gift on death within the recipient's allowance; Spain taxes it under inheritance tax with a small additional allowance for a spouse or descendant | Use the country's own vehicle; forced-heirship rules may reach premiums that were manifestly excessive; the beneficiary clause is the will for this asset and must be kept current |
Equalisation: a worked example
A parent owns a business worth US$3 million and a home worth US$1 million. Daughter A runs the business and will inherit it. Sons B and C get the home between them: US$500,000 each against A's US$3 million. A policy on the parent's life for US$2 million, owned outside the estate and payable to B and C equally, gives each of them US$1.5 million, and A keeps the company whole. Premiums on a guaranteed whole-of-life policy bought at fifty-five are perhaps US$25,000 a year; held for twenty-five years that is US$625,000 for a US$2 million payout, a fraction of the discount a forced sale of the business would cost, and the arithmetic should be redone every five years as the business's value moves. The alternative, A buying her brothers out over ten years from the company's profits, works only if the company survives the founder, which is the thing the family cannot know.
Cover in the last twenty years
Term cover expires, usually at sixty-five or seventy, and the cover an estate plan needs is the cover in force at death. That means whole-of-life or a guaranteed-renewable policy, bought while underwriting is straightforward. After seventy, cover is available, expensive and medically selective; a healthy seventy-five-year-old pays perhaps 8% to 10% of the sum insured a year, and an unhealthy one is declined. The equalisation plan that is only made when the parent is seventy-five is usually made without insurance, and the estate tax plan that is made then is made with a second-to-die policy on both parents, which is the one product still priced for that age.
The insurer conversation
Ask what the policy is for, in one sentence, and make the ownership match. Ask what happens if the beneficiary dies first, if the marriage ends, if the business is sold. Ask whether the nomination or trust is binding, and who can change it. Ask what the policy pays on terminal illness (most pay early on a twelve-month prognosis) and on disability, because the last years usually need the money before the death does. Ask whether the premium is guaranteed or reviewable, because a reviewable premium at eighty is the reason policies lapse a year before they would have paid.
The policy pays the tax. It does not explain the plan.
The child who inherits the business will be asked why. The reasons, in your own voice, can be kept beside the policy.
Insurers and advisers: Make an enquiry
Frequently asked
Is life insurance part of my estate?+
It depends on who owns the policy and who is named to receive it. A policy paid to a named beneficiary or held in trust usually sits outside the estate; a policy paid to the estate, or owned by the deceased in the US, sits inside it.
What is an ILIT?+
An irrevocable life insurance trust: a US trust that owns the policy so the payout is outside the taxable estate, provided the trust bought the policy or the transfer was made more than three years before death.
Should life cover be inside superannuation?+
Often for a spouse or minor children, who receive it tax-free; often not for adult children, who pay tax on the taxable and untaxed components. Take advice on the split.
Can life insurance pay inheritance tax in the UK?+
Yes, and it is the standard answer: a whole-of-life policy written in trust, sized to the expected tax, paid outside the estate within weeks of death.
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