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Life Insurance – Perhaps More than You Want to Know
Life insurance is an integral part of most estate plans. For young adults, life insurance is principally purchased to replace lost earnings. When children are young, life insurance offers the surviving spouse options. No discussion with a surviving spouse is more difficult than the one which brings home the reality that not only have you lost a spouse, but you will likely lose the standard of living to which the family has become accustomed. Young families do not have the financial resources following the death of a parent to provide the children with the educational and developmental op-portunities that were available during the lifetime of the parent. Explaining to a wife following the death of her husband that she must change her standard of living or re-enter the work force in order to provide for herself and her children adds additional pain to that produced by the death of the husband.
As the children age, the need for life insurance may diminish, especially if the family is able to accu-mulate assets for retirement. However, in some cases, the need for life insurance after the children are grown becomes even more crucial.
Consider the case of the family who has accumulated substantial wealth and is looking at substan-tial death tax liabilities even after planning the estate. Life insurance provides the needed cash to pay death taxes. For such estates, especially when the assets are illiquid, life insurance proceeds are important.
Another need for life insurance for affluent families relates to family farms or family businesses. In many cases, only one of the children is involved in the family farm or business. The other children have little or no involvement and have no interest in retaining it. They want cash, not an interest in a business. Life insurance provides needed cash in these situations to enable the family to divide the estate without forcing a liquidation of the family farm or business.
Ownership and Beneficiaries
Like other assets, life insurance policies have an owner. In most cases, the owner of the policy is the insured. In other cases, generally for tax purposes, life insurance is owned by the children or perhaps a trust established for the benefit of the spouse and/or children.
Perhaps the most common mistake made regarding life insurance is a failure to properly structure beneficiary designations. Not only are primary beneficiary designations needed, but alternate ben-eficiary designations are needed to address the situation where the primary benben-eficiary dies before the insured. Structuring beneficiary designations in a manner consistent with the Will or other estate planning documents is most important. For instance, naming minor children as beneficiaries of a
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life insurance policy is never a good idea. That causes the life insurance to be paid into a court supervised guardianship for the minor children. In the case of minor children, life insurance should always be paid into a trust established for their benefit.
It is most important that every policy of insurance be checked to make sure that both ownership and beneficiary designations are consistent with the estate plan. Causing life insurance to be paid in a manner inconsistent with the estate plan can produce significant problems at death.
Tax Consequences of Insurance
There are two forms of taxation which are applicable to life insurance. The first is income tax. The second is death tax. As a general rule, life insurance payable to the family at the death of the in-sured is tax free for income tax purposes. If it is owned by and payable to a corporation (a family business), moving the proceeds out of the corporation may produce income tax.
Life insurance payable to a spouse is free from both federal estate tax and state inheritance tax. However, life insurance payable to anyone other than a spouse is generally included in the estate of the insured for death tax purposes if the insured is the owner of the policy or if the policy proceeds are payable to or for the benefit of the estate of the insured.
In order to avoid including the life insurance policy proceeds in the estate of the insured for death tax purposes, insurance is sometimes owned by the children or placed in an Irrevocable Insurance Trust. This will be discussed below.
As a general rule, there are no gift tax consequences associated with life insurance. However, there is one notable exception. If the life insurance policy on the insured is owned by a third party, such as a spouse, but payable to yet another beneficiary, such as a child, the owner of the policy is deemed to make a taxable gift to the beneficiary when the proceeds are payable at death. Where life insur-ance is owned by someone other than the insured, the policy owner should generally always be the beneficiary.
Irrevocable Life Insurance Trusts
The idea behind these types of trusts is that the insurance policy is not owned by the insured or payable to the insured’s estate. The policy proceeds are excluded from the estate of the insured for death tax purposes. In addition, by causing the insurance to be owned by and payable to an Irrevocable Trust, the insurance proceeds are not payable to the spouse and are not added to the estate of the spouse at his or her later death. Irrevocable Life Insurance Trusts are highly technical tax sensitive entities which require special provisions which are outside of the scope of this news-letter. Reference is made to the firm’s article entitled, “The Irrevocable Life Insurance Trusts” for a more thorough examination of these types of trusts.
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Irrevocable Insurance Trusts are not needed by everyone. However, for estates which will produce federal and/or state death tax, having the life insurance owned by and payable to an Irrevocable Insurance Trust provides the needed cash liquidity at death without adding the life insurance pro-ceeds to the estate. Where the goal is to cause the life insurance policy propro-ceeds to pass tax free, it is often appropriate to pay the life insurance into a trust, often an Irrevocable Trust created for the benefit of the spouse and/or children.
Types of Life Insurance
Although this is an over simplification, life insurance comes in three general types: term, whole life, and universal or variable life.
Term. Term life insurance is typically purchased to provide benefits for a specific period of time. It is not purchased to keep forever. Term life insurance comes in the form of yearly renewable term and fixed term coverage. Yearly renewable term coverage generally provides that as long as the insured will pay the premium for the coverage applicable to an insured of that age, the policy can be renewed annually. Premium payments on this type of coverage go up every five years or even yearly as the insured ages. Such coverage is cheap when we are younger, but becomes expensive as we grow older.
Term coverage is a lot like playing a slot machine at a casino. Consider 1,000 30-year olds who each play the slot machine. Only two will die this year or hit the jackpot, if you wish. The cost of playing the slot machine is equally divided among the 1,000 30-year olds. The casino keeps its share. The two who hit the jackpot win. Term coverage operates the same way. All 1,000 30-year olds pay a premium. Two will die this year and win the jackpot. The life insurance company will keep a piece for its expenses and profit. The next year, 998 individuals return to play again. As we age, the number of jackpots that are hit grows and the number of those left playing the machines diminishes. The cost to play each year increases. You typically do not want to be one of the few remaining persons playing the slot machine at age 90. You have already invested more in the life insurance than your family will receive in death benefits.
The second type of term coverage is fixed term coverage which lasts for a fixed number of years such as 10, 20, or even 30 years. The coverage is generally priced a flat rate for the term. The company agrees that if you will pay the premium each year, the policy will remain in force for the agreed upon number of years. Again, this sort of coverage is like gambling at the casino. The only distinction is, at the end of the term for the product, say 20 years, if you have not died and won the jackpot, the coverage terminates. Premiums are lost. Fixed term coverage, such as a 20 year term product, is an exceptionally wise purchase for an individual with young children who wants to have adequate coverage at least through the children’s college years.
Whole Life. Whole life coverage is an old established insurance product. In its simplest terms, it is what it is called. It is life insurance generally with a fixed premium that you agree to pay for your
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whole life. Such policies generate cash values and, in the case of mutual insurance companies, may pay policy dividends. In some cases, dividends may be used in the future to offset premiums as may cash values, but the general rule of thumb is that in a whole life policy you agree to pay the premium for your whole life. As long as the premiums are paid, the policy never lapses. Other types of policies are available with a “guaranteed” death benefit. These policies are by brands of the uni-versal/variable policies referred to below but carry a “guaranteed” death benefit if all premiums are timely paid as required in the contract.
Universal/Variable Life. During the late 70’s and early 80’s, life insurance companies began to pro-mote a new type of policy which we will refer to as universal or variable life. The policy is actually an annual renewable term policy with an investment account. The idea is for the excess premiums over that required to pay for the term coverage to be invested either internally by the insurance company or externally into stocks, bonds, or other investments and for the investment portion of the policy to grow over the years. The idea of these types of policies is that the investment account will grow, thereby reducing the amount of term coverage to be purchased each year as we get older. In theory, the investment assets, or cash values in the policy, might ultimately equal the death benefits by the time we reach 100.
The benefits of this type policy are that the invested funds grow tax free. The policies are marketed based on assumptions that the policy will generate a specific annual return on its invested assets. Often the goal of these types of policies is to produce enough cash values so that the earnings and investments will pay for the term coverage in the policy allowing the insured in some cases to ultimately stop paying premiums. In these situations, the policy carries itself. It is “paid up.”
These types of policies are excellent where life insurance is needed for an extended period, such as for the entire life of the insured. However, they must be monitored. Investment returns may not be as projected. This is especially the case for universal or variable insurance policies that have been purchased over the last 10 or even 20 years. Interest rates have fallen and investment returns have not met expectations. This produces a lesser cash value than projected which results in more term insurance being purchased each year at a greater premium cost which puts even more pressure on the cash values.
If the premiums and the accumulated investments or cash values are not enough to maintain the policy, the policy will lapse. When policies such as this lapse, it is possible to have an income tax consequence to the insured even though the insured received nothing at the time the policy lapsed. Accordingly, in the case of universal or variable type insurance policies, it is imperative that you review the policy performance, not only comparing the actual performance with that which was projected, but looking to the future to see how the policy is expected to perform based on adjusted return assumptions. Individuals owning such policies should, at least every three to five years, re-quest an “in-force” ledger from the insurance company which is designed to show how the policy is performing and how it is expected to perform in the future based on the assumed rates of return.
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What the author has observed and would submit as a rule of thumb is that when a policy which has cash values reaches the point where the cash values are not increasing every year, but remain flat or begin to fall, in most every case, even if premiums are being paid, the policy lapses within 10 years. Monitoring how cash values are fluctuating is extremely important.
Conclusion
Life insurance is a valuable asset. It provides money for the family to pay death taxes, and facili-tates the division of assets. Like all other investments, it should be reviewed periodically. Policy performance and the financial stability of the company should be reviewed to assure that the death benefits will be there when they are needed.
A. Stephen McDaniel
Wyatt, Tarrant & Combs, LLP 901.537.1000
