Life Insurance

*Photo by Memphis CVB is licensed under CC 2.0. *

Life insurance can play an important part in almost all estate plans. Whether you have very few assets and need insurance to provide for your loved ones after your death or have a very large estate and need more complex estate-planning techniques, its usefulness runs the gamut from the small to the very large estate.

In this post, I will provide a brief overview of life insurance. In a future post, I will discuss more complex estate-planning techniques using insurance, including the irrevocable life insurance trust, or ILIT.

Types of Policies

There are three main types of policies:

1. Whole life: a policy that remains in effect for the beneficiary’s whole life—thus the name. It generally requires regular payments for life, though some policies allow for larger payments over a period of years or even one very large payment upfront.
2. Term life: a policy that provides proceeds if a person dies during the term secured. There is generally no actuarial value to this.
3. Universal life: this is a hybrid plan. It is essentially a term policy with a savings account attached to it.

Basics of Life Insurance

We generally consider life insurance as a means by which we can provide for our families after we’re gone. The cash payouts these policies provide can help meet the needs of loved ones, the idea being that the proceeds should take the financial place of the individual who has passed.

Life insurance, however, can play a variety of roles.  For example, it is common among business partnerships, LLCs, and closely held corporation as a means to buy out the shares of a deceased partner, member, or shareholder. Such business relationships are generally considered to give rise to insurable interests (see below), so that business partners may take out policies on each other.

If the estate tax is a concern for you, life insurance must be handled very carefully because its proceeds will be included in your taxable estate if not treated properly. Generally, insurance proceeds can be included in your estate if (1) the policy is paid to your estate or the executor of your estate, or (2) if you own the policy on your own life and can exercise incidents of ownership on the policy—which, while never precisely defined by the tax code, do include the ability to change beneficiaries and take out loans against the policy, among other things.

Consequently, without careful planning, the government may take nearly half of your insurance proceeds after your death. In a future post, I will discuss the ILIT as a way for larger estates to avoid this result.

Proper planning can also be particularly valuable for larger estate because not only can it prevent the proceeds from being included in the taxable estate, but it can also allow the proceeds to serve as a means by which to pay any estate taxes due. This helps prevent families from having to sell off assets—such as a business or family farm—to pay the bill from the death tax.

Finally, life insurance can provide additional diversity to an investment portfolio. While term life is probably the most common and easiest to understand of the policy types, it generally has no inherent cash or long-term value. Whole life and universal life policies, however, provide an underlying investment vehicle. Earnings on reserves of policies accumulate tax-free and can offer a low risk—and often low yield—return to diversify investments.

Terminology

The world of life insurance comes with its own vernacular. Below is a list of the common terms associated with these policies:

1. Insurer: this is the company or organization providing the insurance. MetLife is a well-known insurer.
2. Insured: this is the person whose life is covered by the policy.
3. Applicant: this is the person applying for the insurance. While the insured and applicant are often the same person, this is not always the case, such as when parents take out policies on their children.
4. Owner: this is the person who owns the policy. This is usually the applicant, but it does not have to be. Ownership may be transferred to another person.
5. Beneficiary: this is the person who will receive the proceeds from the policy.
6. Policy proceeds: these are the funds paid out by the policy.

It is important to recognize that you may not take out a policy on just anyone. There are restrictions imposed to prevent the use of life insurance as a speculative “investment” vehicle. Otherwise, there could be countless people taking out policies on troubled celebrities in hopes of securing a large payout. The morbidity of this—among other reasons—has resulted in the prohibition of such practices.

So, in order to take out an insurance policy on someone, you must have an insurable interest in the person’s life.  To have an insurable interest means that you will be affected by the person’s death, and simple emotion impact is generally not sufficient.

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See Also:

Planning with Life Insurance

Irrevocable Life Insurance Trust (ILIT)