The Need for Life Insurance
Volume 2 • Issue 5 • May 2012
The Counselor is a monthly newsletter of Hallock & Hallock dedicated to providing useful information on estate planning, business succession planning and charitable planning issues. This month's issue will discuss life insurance and its many uses. If you are interested in learning more about the ideas and processes discussed in this newsletter, please contact us for an initial consultation.
One of the more challenging financial experiences is trying to figure out one's life insurance needs. Many of us have a genuine fear of being underinsured, especially in the days of lengthening life expectancies and rising costs of living. How will my family pay the mortgage, pay for college, etc., and maintain the same standard of living should something happen to me?
There are several types of life insurance, including term, permanent, and survivorship or second-to-die insurance. Term insurance, which includes annual renewable and fixed-level term (for example, 20-year Level Term) is temporary in that at the end of the term, the policy terminates and the insured must reapply at the then-going rates, based upon age, health, etc. Therefore, term insurance is often recommended for temporary needs.
Permanent insurance, of which there are several types including whole life, universal life, and variable universal life, are intended to remain in-force until the insured’s death, and thus are often recommended for permanent needs.
Survivorship or second-to-die insurance pays out at the death of the survivor. Therefore, second-to-die insurance is often recommended in those circumstances where the liquidity need arises only at the second death; for example, with a married couple, the need for liquidity to pay estate taxes.
Sometimes the purchase ends in frustration as we don’t understand what we have purchased or what purpose it serves. In estate planning, life insurance is truly a Swiss Army Knife. It is a first option in solving many problems. Perhaps the soundest approach to purchasing life insurance is to consider personal "needs." Some common uses for life insurance are:
Income Replacement. Life insurance can replace lost income for those of us who die unexpectedly. For example, what funds will be available to pay everyday bills? This use is particularly important to families with young children. In determining the amount of life insurance necessary for income replacement, consider the following needs:
A "transition" fund to pay at least six months' bills during the grieving period;
An "emergency fund" for a catastrophic illness or injury, sudden and unexpected accident or casualty, financial collapse or the like;
Funds to pay off mortgages and other debts; and
Funds to supplement or replace Social Security.
If you have young children, also consider an amount sufficient for child-rearing, college and post-graduate expenses, career help and even the cost of marriages.
Wealth Replacement. The traditional wealth replacement use for life insurance was to replace wealth lost to the federal estate tax. However, in 2012 the exemption to the federal estate tax has increased (at least temporarily) to $5.12 million per individual or $10.24 million per married couple. As a result, fewer individuals are subject to federal estate tax, and thus few individuals need life insurance solely for the traditional wealth replacement need.
Life insurance also satisfies other wealth replacement needs. For example, many of our most significant assets are tax-qualified plans (such as IRAs, 401(k)s and pension plans). Because these are a special class of assets, they are subject to ordinary income tax when distributed to our beneficiaries. Given the statistics that beneficiaries often deplete these assets quickly, they will incur significant income tax in withdrawing these assets. Therefore, a million dollar IRA may be worth only $650,000 after federal income tax, less after state income tax. Realizing this, many of us would benefit from life insurance designed to replace this lost wealth.
Other wealth replacement needs for life insurance include:
Funeral and other last expenses; and
Estate administration expenses, including medical bills, hospital costs, decedent's debts and bills, taxes, fiduciary's commissions, attorney's fees and probate costs;
Wealth Creation. A third basic need for life insurance is the creation of wealth. Examples of this need are families who wish to add to their wealth for future generations or to fund their philanthropic objectives. Wealthy families often use life insurance for the creation of additional wealth.
Inheritance Equalization. In planning for family businesses, often only one child will be inheriting this asset. This can result in a significant disparity between the inheritance of one child as opposed to the remainder of the children. Life insurance is often used to reduce this disparity while still allowing the one child to receive the business.
Special Needs Planning. Life insurance is often an excellent tool to provide funding for a Special Needs Trust. The proceeds of the insurance are utilized to benefit the special needs beneficiary in areas not covered by needs based government assistance and avoid the need of relying on the financial resources of siblings.
Buy/Sell Agreements. You can successfully plan for the future disposition of your business through a properly structured buy-sell agreement. This agreement can provide for the sale of your business to a co-owner, employee, family member or other interested party. Not only does it create a ready market for your business, it also establishes the method for valuing the business at the time of sale.
The agreement should also include how payment will be made for the business interest. Options include: cash payments from savings, borrowing, installment sale, or life and/or disability income insurance. Since death and disability can occur without notice, planning to save for these events may be impractical. A savings account established for this purpose may not have accumulated sufficient funds when they are needed. With the loss of an owner who is a key figure in the success of your business, loan institutions may be reluctant to lend money to the company at the precise time it is needed. Selling the business through an installment sale requires that the former owner’s heirs rely upon the future success of the business in order to receive payments.
A buy-sell agreement funded with life insurance is often the most economical and practical solution when a business owner dies. If you use life and/or disability income insurance to fund the obligations under the arrangement, you can be assured that CASH will be available when you need it. Life insurance also covers the risk of premature death by providing an immediate death benefit that is generally received free of federal income tax at the death of the insured owner. Where cash value life insurance is used, the life insurance policy may serve double duty, providing both death benefit and cash value that accumulates on an income tax-deferred basis and that can be accessed through withdrawals or loans for lifetime buyouts.
Key Employee Protection. When a key employee, on whose talents, managerial skills and experience you depend, is lost because of disability or death, the financial loss to your business can be devastating. Creditors may become nervous about extending credit. The goodwill you have worked so hard to establish may be diminished by a change in management. But you can protect your business from such a loss through the use of life or disability income insurance. Life insurance proceeds or disability income benefits will be paid to the business to be used to help meet debt obligations, offset lost sales or cover the expenses associated with recruiting, hiring and training replacement personnel.
Irrevocable Life Insurance Trusts
Life insurance proceeds are not subject to income tax. However, if the insured owns the insurance policy, these proceeds will be included in the insured's gross estate and, therefore, be subject to federal and/or state estate tax. One simple way to avoid this result is to use a properly drafted and maintained Irrevocable Life Insurance Trust (ILIT). An ILIT that owns the life insurance can avoid federal and estate tax on the life insurance proceeds. Such a trust can also ensure that the life insurance proceeds are available as you intended.
Life insurance is a unique asset in that it serves numerous diverse functions in a tax-favored environment. It is a tool that can be used for a variety of well-considered purposes. We recommend that a quality life insurance professional be part of your planning team to help ensure that your life insurance is an integral part of a comprehensive financial and estate plan.
This Newsletter is for informational purposes only and not for the purpose of providing legal advice. You should contact an attorney to obtain advice with respect to any particular issue or problem. Nothing herein creates an attorney-client relationship between Hallock & Hallock and the reader.