Posted by Steve | Comments Off
While most people understand the primary idea behind life insurance – wage earners spend a little each month on a life insurance plan so that if they die, their dependents can enjoy some degree of financial security without their income – most do not understand the whole picture. For example, do those who are financially secure need life insurance?
Most individuals will say no, but the experts say, yes!
Traditionally life insurance is an investment because of the death benefit. Unlike equities, life insurance is a (some would say heavily) well-regulated industry that guarantees eventual payout assuming the client pays the premiums – an advantage that may not have sounded important a few years ago, but is likely more appreciated by everyone studying their equity portfolios today.
Life Insurance Advantages
In general, financial advisers see life insurance as a long-term investment useful to most of their clients. Life insurance has three primary advantages over other types of investments:
- favorable tax treatment
Let’s go over each of these advantages in a little more depth.
The question about certainty, that is whether life insurance will pay out or not is invalid, of course. The real question is how much the policy will pay out. As you well understand, the sooner the insured dies, the better the return on investment – this is the perverse truth about life insurance, and it’s true even for the types of policies used as investments, those that are whole life insurance policies. These require the insured to pay relatively higher premiums while they are young – to offset, of course, a potential payout if it becomes necessary. With these policies, part of each premium (the monthly cost of the policy) is isolated as cash value. This cash value is eventually used to keep premium costs lower as the person grows older. These cash values grow tax-free over the life of the policy and continue to remain so unless the owner makes a withdrawal while they are alive.
Life insurance is considered liquid because the insurance company is obliged to pay the proceeds as soon as a claim is filed. It’s also considered liquid because life insurance, in general, sidesteps probate. Liquid cash always has an advantage because it can be used immediately to buy things and it’s of particular advantage for an estate. Without that liquid cash, heirs may be stuck trying to pay estate taxes and may be forced to sell substantial property or other assets in order to pay them. So, having the balance of the life insurance proceeds can often mean significant savings for the insured’s heirs.
Lawmakers see life insurance as a hedge against catastrophic loss rather than a true investment and so it has retained, over the years and over the passing administrations, significant tax advantages. Specifically, all of the cash value collected in a permanent life insurance policy grows tax free. This includes the cash value in policies that move away from the classic life insurance model and instead serve as a wrapper for equity investments. This wrapping method can be especially useful for wealthy or affluent investors who invest their money in hedge funds, because short-term trades don’t benefit from low capital-gains rates. In almost all cases, life insurance can be passed on to heirs tax free as well. With federal estate taxes slated to return in the near future, those who want to avoid that particular tax may find setting up a special life insurance trust with a trusted individual as trustee will give them additional tax benefits. With the buyer/insured no longer in direct possession of the policy, it is not included in their estate and the proceeds of the policy can be distributed free of tax.
Other Advantages of Life Insurance
Life insurance policies also help those in the position to make large donations or gifts during their lifetime. In most cases, such transfers are subject to a gift tax, but an additional advantage of a life insurance trust, is that it accumulates cash over a rather long time. That is, over the life of the insured. When properly drafted, a life insurance trust can benefit from an annual contribution up to $13,000 for each beneficiary without being subject to gift tax. Those annual contributions are allowed to grow tax free and can eventually become a fairly significant sum. With the proceeds passing on without being subjected to additional income, estate, or gift taxes, it’s an excellent method for distributing comfortable sums of cash to your heirs. Of course, the key to this method is getting started early.
When you are making large contributions to a life insurance trust later in life, the gift tax will not be too great because the amount of the gift isn’t the amount the policy will eventually pay out, but rather the amount needed to pay the premium for a particular term. Also, the gift tax can be reduced even further by implementing some complicated planning techniques. Instead of paying the gift tax yourself, for example, you might loan the money to your life insurance trust to do that for you. This is only useful when interest rates are at favorable rates because you wouldn’t normally want the trust to have to make big interest payments (and interest-free loans are strictly limited under the tax code). With interest rates currently at rock bottom, you could loan the money to your trust for very little.
If you loan the insurance trust the money to purchase the policy outright, you could avoid the gift tax altogether, but that would require a larger and potentially costly loan.
Short-term Life Insurance – useful or no?
While the benefits of long-term, or permanent, life insurance are clear, the benefits of short-term policies is more debatable as it eliminates many of the advantages held by long-term life insurance. One of the advantages of permanent life insurance is that you can still indirectly access the policy’s current value – even after you have formally given it to a trust. This is because the trustee can always borrow against the cash value of the policy and loan you that money. If you don’t pay the money back, the depleted cash value may mean insufficient funds to completely pay the premiums on the policy in later years, which ultimately reduces the payout. On the other hand, individuals setting up life insurance trusts can take comfort in knowing their money is available if they absolutely need it – a technique that is not the case for many estate-planning techniques.
Some investors ‘overfund’ their life insurance policies with more cash value that is needed. Some experts consider this a useful investment technique because it avoids income taxes, and others aren’t so sure because there are other forms of financial planning that are far less cumbersome and don’t involve the charges imposed by many insurance companies. Rarely, however is an estate plan created without a life insurance component. With estate taxes set to return to over 50% soon, affluent investors would be well served to look into life insurance for a life investment.