Life Insurance: What makes this financial tool unique?
Everyone knows that life insurance is a contract where premiums are paid in exchange for a lump-sum death benefit payment upon the death of the insured. What some people don’t know is that life insurance can be used for purposes other than the basic needs of the beneficiaries.
There are a several types of life insurance including Term, which is designed for only a certain period of time, and various permanent products such as Whole Life and Universal Life (which includes Equity Indexed Universal Life, Guaranteed Universal Life and Variable Universal Life). Each type has its own benefits, which are explained below, and each can serve a purpose as a tool in financial planning.
Term insurance covers a duration of time and typically has a much lower premium than permanent products. The premium will stay the same during the entire term, which conventionally would be 10, 15, 20, 25 and sometimes 30 years. The lower premiums and temporary nature of Term insurance make it ideal for providing family security in the event of death while children are young (for example, paying off a mortgage, replacing income or paying for a child’s college). Term insurance is also often ideal for funding company buy-sell agreements and key-person insurance to keep a business running. The unfortunate side with paying lower premiums is that Term insurance doesn’t develop cash value. Meaning, when the term is over, the premiums will increase significantly so the policy is usually allowed to lapse. Of course, the insured can re-apply for a new term policy, almost certainly with a higher premium.
Whole Life insurance is different in that it is a form of permanent insurance which provides lifetime coverage. Being that it is a lifetime coverage (permanent) policy, the premiums are much higher compared to a Term policy. A Whole Life policy has a cash value component which acts as a savings account – as you pay a fixed premium, a portion of the premiums add to the cash value. You can surrender/cancel the policy at any time and collect the cash value (net of any surrender charge), and you may also take a loan out against the policy’s cash value.
Universal Life insurance includes, Equity Indexed Universal Life, Variable Universal Life and Guaranteed Universal Life. Universal Life is a form of permanent life insurance that gives the owner flexibility with respect to the amount and frequency of premium payments. Equity Indexed Universal Life allows the policy owner to receive a credit to cash value that mirrors an index such as the S&P 500. There is often a cap on how much you can make and also a floor to limit losses. A Variable Universal Life policy will allow a person to invest their cash value in separate accounts which can include equities, mutual funds, ETFs and bonds. Lastly, a Guaranteed Universal Life policy has a death benefit that is guaranteed and the policy will not terminate even if the cash value is depleted.
Other than meeting basic needs for a surviving spouse and family, life insurance can be used as a financial tool to help with estate taxes, fund a Buy-Sell agreement and enhance charitable giving.
Estate tax planning can be a complex planning process and life insurance is a great tool to help mitigate estate taxes. Once an individual’s estate is over the $5.49 million exemption ($10.98 million for a married couple), taxes must be paid on the remaining value of the estate at a rate of 40%. Estate taxes are due nine months after death and, in order to have sufficient cash to pay for the estate tax, instead of liquidating assets, purchasing life insurance is a sound financial decision. If you decide to purchase life insurance for estate taxes, you should not own the policy personally. Setting up an Irrevocable Life Insurance Trust to own the policy will keep the death benefit out of the taxable estate and provide the added benefit of asset protection.
Smart business owners use life insurance when they form a buy-sell agreement. A buy-sell agreement controls what happens to the company when one of the owners passes away. Business owners will buy life insurance on each other and, when one owner passes away, the death benefit, usually equaling the interest in the business of the deceased owner, will be paid out to the surviving family in exchange for the interest in the business. This transaction allows the business to continue as normal and ensures the surviving business owner maintains control.
Lastly, life insurance can be an important tool to enhance charitable giving, such as with a Charitable Remainder Trust (CRT). A CRT is an excellent, codified method of deferring capital gains tax upon the sale of an appreciated asset. Instead of selling the appreciated asset outright, paying the capital gains tax and then receiving income from investing the net amount, the owner gives the asset to the CRT prior to selling. Then, when the CRT sells to the third-party, no capital gains tax is paid since it is a charitable entity. The CRT is required to pay an income stream back to the donor and, since no capital gains tax was paid, it can often be higher than if a CRT was not used. At the end of the term of the CRT (often upon death of the donor) the remaining assets of the trust go to charity. So far, both charity (receives asset at end of term) and the donor (charitable deduction and increased income stream) have improved their situations. But what about the heirs who would have otherwise inherited the asset? That is where life insurance comes in. Using a portion of the increased income stream, a life insurance policy can be purchased to replace the amount the heirs would have received net of tax. Many times the end result is that charity benefits, the donor receives more income during life and the heirs receive the exact same amount – a win/win/tie.
There are many uses for life insurance, from covering such basic needs as replacement income, college costs and funeral expenses, all the way to more complex planning such as estate planning, charitable planning and business buy-sell agreements. For each of these uses, depending on one’s goals, one or more of the types of life insurance may be a fit. An advisor at Nichols Wealth Partners can help you explore your options.