A life insurance policy can be an effective way to leave money to your heirs. The death benefit is paid directly to the policy's beneficiaries and is usually 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 others rely on you financially, consider purchasing life insurance to replace your income first.

How does a life insurance payout work?

When you purchase a life insurance policy, you decide how much coverage you want. In most cases, the face value of your life insurance policy is the amount of money paid to your beneficiaries if you die. This is referred to as the "death benefit." Beneficiaries of life insurance policies frequently have the option of receiving the payout as a lump sum or in installments.

What type of life insurance should you use as an inheritance?

Term life insurance and permanent life insurance are the two main types of life insurance. Term life insurance covers you for a set number of years, such as 10, 20, or 30 years, whereas permanent life insurance covers you for the rest of your life.

Consider permanent coverage, such as whole life insurance, if you want a long-term policy that could last your entire life. Consider term life insurance if you need temporary coverage while you accumulate wealth.

Both approaches have advantages and disadvantages. Term life insurance is significantly less expensive than permanent life insurance, but if you outlive the policy, your beneficiaries will not receive a payout. Permanent policies typically cover you for the rest of your life, but larger policies can be costly.

If you're just looking for cheap life insurance, a term policy is probably a better option.

Benefits of using life insurance as an inheritance

The payout goes directly to your beneficiaries

In general, the death benefit is paid to the person or entity you name as the policy's beneficiary, not your estate. This means that the funds will not have to go through probate or be used to pay off any outstanding debts before they reach your beneficiaries. In short, regardless of how your estate is handled, your beneficiaries receive the payout.

Important: If no beneficiaries are named on the policy, or if all beneficiaries are deceased when you die, the payout is usually included in your estate. To avoid this, ensure that the beneficiaries listed on the policy are correct and up to date. It's also a good idea to name a contingent beneficiary. If the primary beneficiary is no longer alive when the policyholder dies, this person or entity receives the payout.

Even if the payout is made directly to a beneficiary, the funds are still taxed as part of your estate if you own the policy. The federal estate tax exemption amount is $12.06 million in 2022 and $12.92 million in 2023.

The death benefit is tax-free

In general, life insurance is not taxable, which means that the proceeds are not subject to income taxation.

Beneficiaries may be required to pay tax on any interest earned on the principal. This is common when the beneficiary receives the payment in installments. While the principal is held by the insurer, it can earn interest. Beneficiaries must pay tax on interest but not on principal.

If you live in an inheritance tax state (Iowa, Kentucky, Maryland, Nebraska, New Jersey, or Pennsylvania), your heirs may be required to pay tax on the money they inherit from your estate. A life insurance policy, on the other hand, is typically considered separate from your estate and is not subject to this tax.

Your beneficiaries can use the payout for any purpose

Life insurance allows you to leave money with no strings attached. That is, your beneficiaries are free to spend the money however they see fit. This is not the case with some types of insurance, such as credit life insurance, which is typically used to pay off debt.

Things to consider before buying a policy

Because life insurance rates are determined by your health and age, the cost of coverage may be out of reach if you are older or have a preexisting condition. According to Quotacy, a brokerage firm, the average annual premium for a $500,000 whole life policy for a 60-year-old man is $17,735. If you can't afford the premiums or are denied coverage, you might want to think about other ways to accumulate wealth. Discuss your options with a fee-only advisor.

Leaving an inheritance isn't the only reason to buy life insurance. Here are some other common reasons for purchasing a policy.

• Utilizing life insurance to supplement your income
• Burial insurance is used to cover final expenses.
• Buying life insurance as an investment
• Using life insurance to pay off debt