Life Insurance: What You Need to Know

The question of what type of life insurance is most suitable, typically has to do with factors pertaining to an individuals net worth. The first thing one should keep in mind in all forms of insurance is that insurance is a contract of indemnity. Meaning it serves the sole purpose of replacing a potential loss. Thus we would not insure a home if we did not own it. It should generally not be viewed as an investment vehicle.

In the case of life insurance, policies are often sold to individuals as a mechanism for saving monies on a tax deferred basis. This is most common in what is called “permanent insurance” (Whole Life, Variable Life & Universal Life). In the case of the vast majority of Americans whom have a life insurance need, the cost of insurance can be kept quite low with “Term Insurance”. Term insurance is designed to cover an individual for a specific term period, usually 10-30 years. At the end of the policy, should the policy holder survive there is most often no accumulated cash value. However the cost is substantially less than comparable forms of permanent insurance. Since the objective is first and foremost to protect against a loss, then obtaining the maximum amount of insurance at the lowest cost is typically the suitable solution. As an example, a relatively healthy male at age thirty can obtain $1 million in coverage for 20 years for less than $500.00 per year.

What about tax benefits of permanent insurance ???

While it is true that permanent insurance can provide an individual the ability to accumulate cash on a tax deferred basis, this is rarely a sensible option. Many policy holders are making contributions to policies before they have made the same maximum contribution to their employer sponsored retirement plans (401k/403b). Often this may even mean they have yet to extract the entire matching contribution their employer is making on their behalf and potentially leaving behind money that should have been allocated toward their retirement. Additionally, contracts such as Variable Life policies with investment sub accounts typically come with extraordinarily high hidden internal fees. If you’ve already made the maximum contribution to your employer based retirement plans as well as an IRA and still have some discretionary cash flow to save toward retirement with, there are some other options.

One such option is a tax deferred annuity. Such products are also often quite expensive and not worth the added cost. However, there are a few companies that have created tax deferred annuities with extremely low expenses. It is important to discuss the internal cost structure with your advisor to see if such a vehicle makes sense. Additionally, be wary of surrender charges for such products. They often come with many liquidity traps that require an investor to be very prudent in investment selection. In the case of permanent insurance the greatest tax benefit is usually aligned with estate planning using a strategy known as an “Irrevocable Life Insurance Trust.” Such a trust can be designed to reduce both the Federal and State estate taxes on ones assets at death. Since these trusts must exist for the duration of your life to be effective, term insurance is not a reasonable solution. However over the last few years, the burden of federal estate taxes has been reduced greatly. Currently one would typically need a taxable estate of more than $5 million ($10 million for a couple) to justify this strategy. Hence they have become far less common. It should be noted that recent tax law changes are set to expire at the end of the year 2012, and could greatly alter the benefit of such an approach. In states where the state itself levies an estate tax, this approach should be reviewed.

Additionally small business partners whom are concerned about inheriting their partners spouse as a their new partner could benefit from a buy/sell agreement. This is an approach where a contract is drafted between two or more owners to insure eachother. The proceeds at death are used to buy out the ownership interest from the spouse of the deceased party. Again this is generally best funded with a form of permanent insurance to avoid the risk of the business entity lasting longer than the policy time limits of a term policy. Since these policies typically are drafted in a seperate partnership outside of the business entitiy for tax benefits, they can get quite complicated. Thus one should consult with not only their financial planner, but also an attorney specializing in tax, business sucession and estate planning law for further clarification.

What if I already own a permanent insurance policy ???

In such cases each policy should be reviewed on its own merits. In some cases where the current cash value is well below the death benefit and the individual is further on in years, it may be advisable to keep the policy in force. In cases where the accumulated cash value is sizeable and close to the death benefit to be paid, there are other options. One such option is to convert the cash value to a long term care policy in what is known as a 1035 exchange. Such an exchange alters the tax status of the policy from tax deferred to tax free, as long as the proceeds are paid directly to the long term care provider in the 1035 exchange. It is important to evaluate the need for the LTC coverage first and then the policies benefits separately before making such a commitment. If the long term care needs have already been met and there is no longer a need for life insurance coverage or you are choosing to replace the permanent coverage with a less expensive term policy, consider the following. It is possible to do a similar 1035 exchange of the cash value to a fixed or variable non-qualified annuity, while maintaining the tax deferred status. You would continue to grow the assets on a tax deferred basis, yet no longer be subject to paying the high premium payments. If you are replacing the policy with a less expensive term policy, it is important to make sure the new policy is in force before completing the 1035 exchange to the tax deferred annuity to avoid the risk of an interim health related event rendering you uninsurable.

What about Educational Funding ???

Once again, you would be far better served to utilize and employer sponsored plan first and then shop for one of the few low cost annuity products available with your financial planner. Both provide the same shelter from FAFSA reporting in cases of applying for financial assistance in educational funding.

What about employer sponsored life insurance ???

While this can often be a good option, there are areas of concern. The first of which is portability rules. In society today many Americans fail to spend their entire career with one employer anymore. It’s important to inquire as to whether your potential policy is portable, meaning can you maintain it in the event of a career change. Most policies today do have portability features. However you should inquire before issuing such a policy. The other concern is that your employer may be subsidizing a substantial portion of the cost. If so, then be prepared to account for that subsidy at your own expense once you leave the employer. Since most employer sponsored life insurance plans are forms of permanent insurance… that can be a sizable difference in premium payments. Should you have unfortunately developed a health related issue since the policy was first issued, that may make it unlikely for you to qualify for your new employer’s group plan or a seperate individual policy as a replacement. This scenario could leave you with a very expensive policy, that you may have difficulty keeping up with. In cases of young families with children, you may be placed in a difficult bind of needing to maintain a very expensive policy. However, had you initially purchased a less expensive term policy on an individual basis, the status of your employment would have no bearing on the cost of the policy.

Who should be insured ???

The question of who should be insured is anyone of economic value that needs to be replaced. Hence a non-working spouse whom is caring for children can be extremely costly to replace. Aside from the emotional loss of a spouse, a full time day care facility or nanny can be budget busting and place a terribly costly burden on a young family.

What about pension replacement ???

In many cases insurance policies are issued in place of a joint survivor option on a spouse who recently began collecting a pension. This often seems to be an attractive and cost effective option in the early years of retirement. However, as time goes by it becomes less practical and usually not the best solution. The suggestion from the insurance agent often references the fact that the cost of the policy is less than the reduced joint survivor benefit. However, with permanent coverage the premiums are not always fixed. They either rise substantially over time or start off with an extremely high cost of insurance making this option less attractive. And the amount of insurance required to replace a lifelong pension benefit with an equitable income is quite a bit, making permanent insurance unaffordable later in life. All too often clients have taken this approach not realizing that the amount of insurance issued is insufficient to meet the annualized income necessary for the surviving spouse to replace the pension benefit of the deceased spouse. Due to the time limits of a term policy, it is often not a suitable solution either. In the majority of cases the reduced pension benefit with the survivor option for the spouse is most suitable. It tends to amount to purchasing a term policy without a term limit. It is important to consult a financial planner on such matters whom does not sell insurance. Most insurance agents receive 50% of the first year’s premium as commission compensation for that sale of an insurance policy. So the incentive to sell the most cost effective policy to you is not necessarily there.

As with all financial solutions, there is not a once size fits all. There is a time a place for most every product as a potential solution. And each client circumstance should be evaluated individually to find the most appropriate fit.
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