A life insurance policy can be an important part of an estate plan for a few reasons. First, the payout is not counted as taxable income. Also, the payout processes more quickly than a lump sum bequest. While your personal representative goes through the valuation of your estate, combing through assets and liabilities, your beneficiary will be able to put a down payment on a house or pay for a college education right away.
Some life insurance policies have a cash value as well. The idea may conjure the image of George Bailey in "It's a Wonderful Life," but taking advantage of a policy's cash value may be a little more complicated and a little less dramatic than that.
The first thing to understand is whether your insurance is a term or a permanent policy. With a term policy, you purchase the insurance for a set premium and a set period of time. For example, you purchase coverage for $100 per month for a 5-year period (the policy term). If you die during those five years, the insurance company will pay the benefit. If you don't die, though, the insurance company is off the hook.
Permanent life insurance is more expensive, because the insurance company is promising to pay when you die, even if you live for another 50 years. As long as you pay your premiums, the insurance company is bound to pay the benefit. In many cases, too, a portion of the premium is set aside in a savings account of sorts, where it collects interest. This savings account is the cash value of the policy.
If you own your permanent life insurance policy -- that is, if you pay the premiums and are the named insured -- and find yourself short of cash, you have a number of options. For example, you can use the cash value of your policy as collateral for a loan. Or you can withdraw all or a portion of the cash value. The advantage here is that the portion you contributed through your premiums is tax-free. The down side is that the interest is not tax-free.
A life settlement may also be an option, but be warned: Michigan does not regulate life settlements. You will need to do some research, and you may want to consult with an estate planning attorney before you take such a bold step.
What's so bold about a life settlement? We'll explain in our next post.
Source: NerdWallet.com, "Before Death Do Us Part: Selling Your Life Insurance Policy," Alice Holbrook, May 5, 2015