Life Insurance - A Primer for Potential Buyers
Tailor it to your needs
By Jonathan Bell
As this column is being written, the Senate has just decided, largely based on an expressed desire to avoid higher budget deficits that our children would have to pay for, not to take up the issue of estate tax repeal – at least for the short term and probably until after the fall elections. But Congress also appears to have decided not to take up the question of estate tax reform, either.
That may not make sense, since everyone in Washington has to admit that the current estate tax system is almost completely irrational: It’s scheduled to go through a series of huge swings involving another substantial reduction, then total elimination and then “resurrection” at a significantly increased level, and all within the next five years!
That’s politics, right? Well, yes, but it could dramatically affect your life insurance needs and how your insurance should be owned. So it would be nice for all of us to have more clarity about the estate tax picture.
How, you may ask, is this relevant to whether you should buy life insurance, and if so, what kind? Well, besides the fact that the life insurance industry has, predictably, lobbied very hard to retain the estate tax, what your family will have to pay Uncle Sam when you die is one of several elements that factor into the calculation of your life insurance needs.
Who Needs It?
Of course, life insurance isn’t really “life” insurance, is it? It’s really “death” insurance, because that’s when its proceeds become available, just like fire or flood insurance pays off after those events. And just like these other events, death (especially unexpected or premature death) can have such serious economic consequences for the survivors that it may make good sense to insure against it.
So, who is a good candidate for life insurance? Think about the hard-working parents with several young children and as yet inadequate savings to send the children to college. What about the highly compensated executive whose family recently bought the house of their dreams and taken on a huge mortgage? Or the family with an otherwise healthy but mentally impaired child?
You get the picture: If the source of funding (say, your income or assets) for your family’s future needs could be cut off before you have had the chance to accumulate the resources required to deal with those needs, then life insurance, perhaps large quantities of it regardless of your income level, may make considerable sense. Like many other expenses, those who need it most may be least able to afford it– but here’s hope there, too. There’ll be more about how you can save on insurance premiums later in this column.
Consider, however, that at some point in the future, hopefully, those needs of your family may already have been dealt with while you were still alive. The kids may be through with college and earning their own livings, the mortgage may have been paid; the elderly parents may have passed on (perhaps leaving you with a little something?) – making that life insurance partially or completely unnecessary.
What I am suggesting is that your life insurance coverage should be carefully tailored to your current and anticipated needs, and that those needs may not be permanent.
Do The Math
In calculating your needs, don’t forget that if you have an estate (that is, a net worth) of significant size (more than about $5 million) and particularly if you are passing on assets that your family is unlikely to want to sell the vacation home on that island off the coast, perhaps?), then you have to include in your insurance needs enough to pay the estate tax (which even under the current law will not decline below 40% on the amount over the exemption). But the reality is that you may be able to afford far more insurance than you think, because what you really need is more coverage now and less coverage later.
The secret (okay, it’s not actually much of a secret, except that your average life insurance salesman will not be happy you asked him about it since his commissions will be sharply reduced) is to buy mostly – or only –“term insurance.”
As its name implies, term insurance is only temporary coverage; you have it only for as long as you pay for it – sort of like leasing a home or a car – unlike “whole life” insurance which has permanent value but costs much, much more for the same level of coverage.
Whole Life As An Investment
Paying the higher cost of whole life over term is, essentially, deciding to make an investment with the insurance company and to use it as your investment manager. If you have the cash to buy whole life, you could instead buy term and invest the difference in cost in other kinds of assets, such as stocks, bonds or real estate. There may be some income tax savings involved in buying whole life insurance as an investment, because the proceeds can eventually come out income tax free, but you have to offset the significantly higher (but often hidden) fees that the insurance company will charge, as compared with other investment managers.
One final thought: If you have insurance needs that are significant and buy large amounts of coverage, consider talking to your estate planning attorney about creating an “irrevocable life insurance trust” (or “ILIT” – my readers should know by now that we estate planners have an acronym for everything we can think of) which should be created in advance to purchase the policies.
That way, the value of the insurance proceeds will never be included in your taxable estate for estate tax purposes, and will pass to your family to deal with their needs completely free of any tax. Those life insurance industry lobbyists are no fools: This “gimmick” has survived every effort by the IRS to wipe it out!
Jonathan R. Bell is a partner at Duane Morris LLP. He is a Fellow of the American College of Trust and Estate Counsel. A graduate of Yale College
and Harvard Law School, Bell has been practicing as an estate planner for more than 30 years. You may reach him at jrbell@duanemorris.com.