Life Insurance

Most people recognize one need for insurance: Income protection for the family in case of the breadwinner's untimely death. But many people are unfamiliar with the usefulness of life insurance in facilitating the tax-efficient transfer of family wealth to the next generation. Although this is not an insurance course, a few introductory observations are in order, for those unfamiliar with this subject

Types of Insurance
Special uses of Life Insurance
Problems of Policy Ownership
Discounted Dollars Concept


Types of Insurance

The basic varieties of life insurance are permanent, also called whole life, variable life and universal life, which includes an investment component, and term life, without one. At the time of purchase, a permanent life policy represents the insurance company's promise to provide coverage for the entire life of the insured person, as long as premiums are paid. The basic idea behind permanent coverage is to build up a reserve to make sure the policy stays in force for the life of the insured.  A term policy, in contrast, provides coverage for a specified period of years - the policy "term." (Whether, and at what cost, an expired term policy can be renewed for an additional period of coverage, is another matter entirely.)

Within each variety - term and permanent life - there are many options and features that should be considered, and it can be a complicated process to sort through the choices available. (This is particularly true with permanent life, due in part to the decisions that must be made regarding the investment portion of the premium dollar.) Once you have determined what you need, it is wise to do research and crunch numbers to find the best deal, from among those companies you deem sufficiently sound and reliable.

None of this is rocket science. It is simply a matter of spending some time educating yourself and going through a number of steps. There are plenty of resources on the Internet to help. Obviously, a trusted financial planner  can be an immense aid in this process, but expert help is not essential.

Viewed strictly as an investment, a whole life policy from a quality company can compare favorably with other conservative vehicles, particularly due to the tax-deferred growth of the policy cash value. Term insurance has no cash value, so it is generally cheaper, at least at a younger age. If personal cash-flow permits, the money saved on term premiums, compared to the permanent life alternative, is available for investment by the insured person on his/her own.

Number crunching to evaluate a traditional whole life policy can only be done with information obtained from the insurance company. It is not enough, however, to find an insurance agent you personally trust. It is not he/she, but the company that prepares the policy illustration you are shown. Question the assumptions made in the policy's projected growth in value (for traditional whole life). If the company is investing your premium dollars conservatively - as it should - do not expect to see eye-popping returns. Be suspicious if that is what appears in the illustration.

An alternative to the traditional whole life policy is the variable life policy - in which the investment component and return of the policy (not the insured person!) varies. This is because the insured - not the insurance company - takes responsibility for selecting where the investment portion of the premium dollar goes. He/she selects from a number of options, including many similar to the mutual funds that most investors are familiar with. These are potentially much higher returning investments than an insurance company would make on its own. The stock market, however, is also more volatile and risky than the kinds of investments insurance companies are supposed to make. There is no "right" or "wrong" answer or conclusion to be drawn from these observations. The life insurance buyer simply needs to be aware of the complete picture.

Insurance (all kinds) is not subject to probate proceedings. Policy benefits are paid directly to the beneficiary upon proof of death. A beneficiary who is a named person gets the death benefit free of all taxes and (almost always) the claims of creditors. But if the policy is payable to the estate instead, the proceeds are just like any other asset of the estate, and are subject to creditors of the decedent.

BEWARE ! Most people know that life insurance death benefits are received income tax free by the beneficiary. But regardless of who is named as beneficiary, if the policy is owned by the decedent - as opposed to ownership by a spouse, child, Trust, etc. - the proceeds are included in his/her estate for federal estate tax purposes. This tax is only important for estates totaling $675,000 (in 2000, and going up to $1 million in a few years) or more, but life insurance death benefits are often not considered, and push many people over the limit. Ownership of the policy by an irrevocable Trust may then be advisable to keep the proceeds out of the taxable estate.

Special Uses of life insurance.
 

1. Life insurance proceeds are a guaranteed, quick source of funds for the payment of post-death obligations. Despite maximal planning, substantial federal estate tax might be due. (Remember, after the first $675,000 (for 2000) in estate value, rates start at 37%!) This can present a serious problem when the estate consists of non-liquid assets, like real estate. Life insurance can provide tax money, so that a “fire sale” of assets, to raise cash under time pressure, is avoided. Family business owners often underestimate what their companies are worth for federal estate tax purposes. Insurance can prevent a forced sale or liquidation of the business.

2. Life insurance can and should play an integral part in many buy/sell and other business continuation arrangements. A family's biggest asset and primary source of income might be its share of a business owned by several unrelated partners. When one of these partners dies, what happens to his/her share? Will there have to be a sale to outsiders, or liquidation of the company just to pay that partner’s post-death obligations?

An agreement should be made whereby the surviving owners of a business (or the business itself) are given the right to purchase the deceased partner's share. There are many variations on this theme, but funds must be available to honor the agreement. There are life insurance products specifically designed for this purpose.

3. “Second to die” (survivorship life) policies pay only upon the death of which ever spouse (or other insured person) dies last. Survivorship life policies are relatively new, and there are many variations. They can be either term or whole life.

Frequently, a need is anticipated strictly for tax cash. With the unlimited marital deduction having been used after the death of the first spouse, it is often only at the second death that federal estate tax is actually payable. Likewise, business partners might recognize that ready cash needs to be available to fund their business continuation plan. In these cases, survivorship life insurance can be a cheaper way to go than purchasing two individual policies. A “second to die” policy can also be used as an income replacement fund, for a family able to financially withstand the loss of one breadwinner, but not both.

However, if it is not necessary to keep premiums to the bare minimum, buying even one traditional life policy might be a better overall deal than a "second to die" policy. The rationale goes like this: If you insure one spouse, and he/she dies second, you are in much the same situation as if you had bought a second to die policy, anyway. If he/she dies first, however, the policy proceeds go to the survivor. True enough, this payment comes before the anticipated need. But, so what? The survivor can just invest the money till it is needed.

Survivorship life is definitely something to consider for those in certain situations. One has to lay out options and use real numbers, though, to know if it is the best choice.

The "discounted dollars" concept.

A life insurance death benefit is purchased with "discounted dollars.” The point is that the annual premium will usually be only 1% - 5% of the policy face value, but the full policy amount is available from Day One. So, life insurance is the only investment able to guarantee that a definite sum of cash will be available immediately. The ultimate "discount" will depend on the cumulative premiums paid by the time the death benefit is received.

The "discounted dollars" concept enables substantial wealth transfer at reduced (or zero) gift tax cost. A program of yearly gifts, intended (but not required) to be used by your children (or others) for premiums, can take advantage of the annual $10,000 gift tax exclusion. That way, no tax is paid by anyone on those gifts, and the donor's full $675,000 (for 2000) federal gift and estate tax shelter remains available for use at death. Better yet, the certainty of the death benefit will produce a sizable, predictable, "instant" estate, that can be quickly created and regularly increased by additional premium payments.

The problems of policy ownership.
 

The proper ownership of life insurance is critical to avoiding a variety of unwanted tax consequences. Attorney George M. Turner of California, a respected authority, has estimated that insurance is improperly owned in the large majority of cases, from the tax planning point of view. The situation can be more complicated than it appears.

For example, a major advantage of life insurance is the (generally) income tax-free receipt of proceeds by the beneficiary. This is widely known to the public, and we have mentioned how to avoid estate taxation, as well, on these proceeds upon your death. (An irrevocable Trust can be used to buy and own the policy, to avoid estate taxation. More later.) But without comprehensive planning, the usefulness of these features can easily be lost.

BEWARE ! Visions from "Tax Hell:"

1) Mom owns a life policy on Dad, with the children as beneficiaries. She is careful to pay premiums with her own separate funds, so that Dad won't somehow be deemed by IRS to have strings attached , and the proceeds, therefore, will not be included in his taxable estate.

At Dad's death, the insurance money goes directly to the children, exactly as planned. No estate tax is due. BUT, Mom has made a taxable gift to the kids, for federal purposes, because she "gave" them the policy proceeds! And if the kids put up part of that money to help Mom with the gift tax - if any is actually due and payable - then they will be deemed to have made a taxable gift to Mom!!

2) Beware, business owners, of a common arrangement: A policy on the life of a stockholder (or key employee) is payable to his/her beneficiary, but owned by the corporation, which has paid all premiums. There are a variety of undesirable tax consequences possible, depending on the specific facts of the case. For example, such life insurance proceeds may be includable in the decedent's final income tax return as "income in respect of a decedent." Anything left after income tax might be considered part of the taxable estate!

Fortunately, there are strategies for dealing with these insurance needs in a tax-efficient way. The tax laws applicable to life insurance are exceedingly complex. The essentials can be explained easily enough, however, once you find a trusted insurance agent, from a good company, who is experienced with the concerns and needs confronting you.