CHAPTER
4

Life Insurance

In This Chapter

• Ways insurance can help your estate grow
• Choosing between term and whole life policies
• Determining how much insurance you need
• Naming your beneficiary(ies)

Do you have enough life insurance? No, no, come back. I’m not trying to sell you a policy. I ask because life insurance is an integral part of estate planning.

Force yourself to read this chapter, if you must, but do give the subject some thought. You almost certainly will want to take steps to ensure you know what your own coverage entails, beef it up in areas where it needs emphasis, or perhaps buy insurance in the event you have none.

What Life Insurance Can Do for You

You probably are underinsured. Remember, I am not an insurance broker, and I have no stock in any insurance company, so I have no vested interest in making such a statement.

Sadly, many of us view life insurance like a bad lottery: if we win, we’re dead. We often have little regard for life insurance salespeople as well. (Although I believe they still rank slightly higher than lawyers.)

Still, there are those folks who wisely look and plan ahead and do buy insurance. Life insurance industry statistics for 2014 show that only 41 percent of the adult U.S. population has life insurance, and the average for those who have life insurance is $166,800 of coverage.

There are several reasons why coverage is a worthwhile expenditure. Life insurance …

• Increases your estate, building wealth with a relatively small outlay of cash in the form of premiums.
• Provides ready cash for loved ones upon your death.
• Is received by the beneficiary free of income tax.
• May be owned by someone besides the insured and not be subject to death taxes.
• Can be used to fund a business buy-out plan.
• Could serve as a savings account, if it is whole life insurance.

Let’s look at these benefits in more detail.

Build Wealth

Most of us would like to have as substantial an estate as possible so our loved ones can live comfortably after our death. Unfortunately, most of us—me included—don’t have a rich relative about to pass away and leave us her fortune, nor rich relatives eager to share their wealth during their lifetime through generous gifts. We have to build up an estate the old-fashioned way: by earning money and saving it, or by investing it wisely.

Your estate can be substantial with the inclusion of life insurance. Take me, for example. My 401(k) pension and my house are my biggest assets. When I die, my wife will own both. When we had minor children, I was concerned that she and our children would not have enough to live comfortably, so several years before, I bought term life insurance (I talk about this in detail in the next page or so) with a face value of $450,000. That’s in addition to the group term life insurance I had at work. I knew my family would be financially more secure because of that insurance.

I pay approximately $990 in quarterly premiums for my coverage. I hope my wife and I have many years together, and I’m certainly content with the insurance company keeping the premiums. It’s a small investment for my family’s financial future.

Provide Ready Cash

Life insurance people like to emphasize that your estate may not be “liquid.” This is a genuine concern, and one that some form of insurance protection can address.

Let’s take Ed and Eve as an example. The couple, in their mid-30s, have two young children. They own their own home, have a small savings account, have a little invested in stocks and mutual funds, and both have small contributory retirement plans through their jobs. Ed earns considerably more than Eve, although it could be the reverse with other couples.

If Ed suddenly dies, his salary would end, but the bills wouldn’t stop coming in. The Internal Revenue Service (IRS) in particular isn’t all that patient if you owe them money. The cost of a funeral might be around $6,000, and funeral directors want to be paid, too.

Ed could solve those immediate problems with life insurance, at very little expense. Because he is young, the premium for coverage similar to my policy will be considerably less than what I pay. Should something happen to Ed, Eve can deal with her grief and not have to worry about where the money is going to come from—it’s in the mail from the insurance company.

Single people and couples without children can make use of an insurance policy, too, and for the same reasons: immediate cash for beneficiaries; money to pay funeral expenses; and the deceased individual’s other bills such as repayment of loans, credit card balances, and other debts that have to be satisfied from the estate. Single persons often name children from a prior marriage or near relatives as beneficiaries in their life insurance policies.

As with all estate planning, these beneficiary designations should be changed as personal situations alter.

Business Plans

You also need to consider life insurance if you are the owner, or part owner, of a business. The business could purchase insurance on the life of its owner, and the proceeds could be paid to the business and/or the owner’s next of kin.

A business that has an owner or key employee die suddenly might experience a financial crunch for a short time, or perhaps even longer. That could be alleviated by the insurance proceeds. The owner’s family may need cash but can’t sell his business interest to generate the necessary money. Life insurance can be an answer there, too. (Chapter 6 contains a good deal more about owning your own business.)

Savings

If you choose whole life insurance (explained in detail a bit later in this chapter), your premiums are divided into two parts: one part pays for the insurance coverage, while the other becomes a savings account. If you have trouble saving money, this feature can help you build a small nest egg. Of course, the savings amount of the premium could be used to purchase more term insurance, which would increase that coverage.

Which Policy Is Best for You?

Life insurance coverage is available to fit practically every reader of this book, and at a variety of costs. You just need to determine the type of policy that is best for your purposes.

We can divide most policies into two categories: term and cash value.

Term Policies

Term policies have one common feature: there is no cash value built up by your premiums. This is simple life insurance, offering the most coverage for the least cost. You can select whatever that amount will be—perhaps $50,000, maybe $500,000, or any other number—and pay an annual premium. If you die while you own the policy, your beneficiary receives the money.

You cannot borrow against a term life insurance policy because there is no cash value.

The premium you pay is based on the amount of insurance you purchase, your general health, and your age when you first buy the policy. The premium rises as you grow older. Also, insurance costs vary the way prices of other products do, so it pays to shop around to find the best, safest coverage with a company offering the lowest cost to you.

Here are some varieties of term policies:

Annual renewable This offers 1 year of insurance, usually renewable every year with an increased premium (because you are growing older). This has the advantage of giving you the greatest coverage at the lowest cost. Read carefully any policy you are considering to see what your renewal rights are.

Level Coverage here is for a guaranteed term, such as 3, 5, l0, or 20 years, with level premiums. That means they reach a certain plateau and stay “level” until the next change, or the premium remains the same but the coverage decreases from one level to another. Some insurance companies allow cost-of-living increases at proportionally the same premium.

Decreasing Coverage decreases over a set period of time, but the premiums remain the same. One plus of this program is it provides greater coverage when most of us need it, early in our family lives.

Mortgage or credit With this style, coverage decreases as the debt you are insuring is paid down, but with a level premium. This is expensive, so you will want to consider purchasing another form of term insurance if you want that debt paid off at your death. Buy this only if you are otherwise uninsurable.

Group Many employers carry group term life insurance policies for their employees. It’s a great fringe benefit because the premiums for the first $50,000 of coverage are income tax free, and the employee pays a low rate of income tax on the policy beyond that coverage. My advice is to get as much group term life insurance as you possibly can.

Cash Value Policies

Another option, cash value life insurance, is sometimes referred to as whole life insurance. Most of these policies have, as mentioned earlier, a savings account feature with variables in investment returns.

Here are some cash value policy styles:

Whole (ordinary) Coverage is guaranteed at a fixed amount, with level premiums. Part of each premium goes into a savings account at a predetermined amount and investment return. You can borrow against the cash value of the policy.

Universal The term and cash value portions are split into two accounts. Depending on the insured’s allocation, the insurance can increase or decrease. It does have the flexibility of changing coverage as needs alter, but it’s more expensive than term if the insured uses most of the premium for coverage.

Vanishing premium Here, premiums are overpaid in the early years so the cash value can accumulate more quickly. Then the later premiums are partially paid from the cash value, or the coverage could be reduced or lost.

Joint first-to-die or second-to-die This is life insurance coverage for two persons, usually spouses. It is less expensive than buying two separate policies. The proceeds are payable according to the first- or second-to-die provisions.

Discuss policies you are considering with your financial adviser. (Remember, you are going to call often on your estate planning team.) He or she might be more objective than a life insurance agent. Be sure to have your adviser read the fine print of policies. What the large print giveth, the small print often taketh away.

How Much Coverage You Need

A life insurance company and your financial adviser can help you determine how much insurance coverage is sufficient for you. After your purchase, you will want to review your calculations periodically, perhaps once every year or two, to be sure your coverage matches your current needs.

Coverage amounts are quite subjective, but usually the main purpose of life insurance is to provide a lump-sum amount that will replace the deceased’s income. If you want a quick calculation, here’s a suggestion—keeping in mind that your future income may vary considerably from these guesstimates:

l. Calculate your annual income (reduced by personal expenses for you alone, such as clothing, lunches, and so on). For example: You earn $45,000 after taxes and spend $5,000 on yourself = $40,000.

2. Divide that amount by your expected rate of return from investing the life insurance proceeds. For example: $40,000 ÷ .05 = $800,000.

3. Subtract your current total savings and investments. For example: $800,000 – $30,000 = $770,000, your life insurance needs.

The rough method I used when determining how much life insurance I needed was to add up all my debts—and don’t think that’s not a depressing experience. Then I determined how much money, when invested, would be needed once all those debts were paid. For example: my debts to be paid were $100,000 + investment need for annual income of $30,000 (÷ .05) = $600,000. Therefore, the total I needed was $700,000.

With this kind of need, term life insurance is your best buy. The life insurance industry suggests adults should have coverage equal to 10 times their annual salary.

Don’t forget that if you have college expenses coming up for one or more children, those costs could considerably alter the amount you need.

Who Owns the Policy? Who Is the Beneficiary?

If the insurance is on your life, probably you own the policy. It works that way for most people. You can control premium payment and beneficiary designation because it is your policy.

However, someone else can own a policy on your life. For example, your spouse might own your policy, or perhaps one of your children does. The proceeds are payable to them or anyone they designate. That way, the policy is not subject to federal estate taxes. (See the following section for an explanation.)

If someone else owns your policy, they may look to you to pay the premium, but they need not consider your wishes as to who will benefit from its proceeds after your death. Tax concerns may, or may not, override your choice to have another person own your policy. (We look at this more in Part 4.)

If you are married, you probably want to name your spouse as primary beneficiary of the policy, and if you have children, name them as alternate beneficiaries.

You ought to review your beneficiary designation at regular intervals, especially if your family needs and life situations change. Always ensure that you have an alternative beneficiary because if the primary beneficiary dies before you do, without an alternative named, the proceeds become part of your probate estate. This is generally not desirable because it will delay distribution of the proceeds and be subject to probate costs and, in some cases, state inheritance taxes. You can change your beneficiary designation by using the insurance company form provided for that purpose.

If you have minor children, consider establishing a trust for them to receive the proceeds and manage the assets until they become more mature. (Chapters 9 and 12 talk about trusts for minors.)

Easy Go the Taxes

Keep in mind that life insurance proceeds paid to a beneficiary because of the death of the insured are exempt from income tax.

However, interest earned on the policy is not exempt from income tax. For instance, some policies allow beneficiaries to choose between a lump sum payment or a periodic payment over a number of years. If a spouse chooses the periodic payment option, part of each check will include interest on the amount left with the insurance company. The interest portion is taxable.

If you own a policy at your death, or if the proceeds are payable to your estate, the insurance will be subject to federal estate tax, which begins with an estate valued at $5,450,000 in 2016, with annual adjustments. You can avoid this by transferring ownership to another person, such as an adult child, even if he or she is also the beneficiary. However, transfers made within 3 years of death are subject to the estate tax. Then the proceeds will no longer be included in your estate. However, if the policy has a cash value, the transfer may be subject to a gift tax.

If you do some number-crunching here and see that you can do without your term life policy, all you have to do is notify the company that you are canceling and not continuing payments.

Dropping a cash value policy is more complicated because although those policies are part death benefit, they also are part savings. Check with your financial planner or accountant to see if this is a wise step for you. If you are in poor health, for instance, it might be better to keep the policy in effect. You could be considered uninsurable if you go to purchase another some day.

If you want to go outside your estate planning team, you can send your cash value policy to the Insurance Group of the Consumer Federation of America (CFA). They will analyze your rate of return and give you an idea of what you would have to earn investing to better it. For more information, see the CFA website at consumerfed.org.

Think about it, though. You pay a reasonably small amount in premiums for insurance, and the return on investment can be very large. In my case, with term life insurance, my policy would have paid my wife more than $450,000 when I died; I invested approximately $20,000 in premiums before I cancelled it at age 68. Of course, I prefer not to think about the downside for me personally had that happened, but at least I know the money would have been there for her if I wasn’t.

The Least You Need to Know

• Life insurance can significantly increase your estate at very little expense.
• Work the numbers to determine what your specific coverage should be.
• Term insurance is straight insurance, payable at death, with a low cost compared to the coverage offered.
• Whole life insurance is a combination of term insurance and a savings account.
• Insurance proceeds paid to a beneficiary at the death of a policyholder are exempt from income tax.