Life Insurance Guide

Life Insurance 2021 Updates: Types and Taxation Policy

life insurance
life insurance
Written by Garcia Olivia

Insurance is a concept that most of us know. right?

Introduction to Life Insurance

Life insurance

often seems to elicit a visceral reaction, even though the ultimate event insured—death—is inevitable.

I’ve occasionally heard the statement, “I don’t believe in life insurance.” Fortunately, life insurance is not a spiritual concept that simply requires “belief.” It can be analyzed mathematically.

So either it will make sense or it won’t in any given situation.

There are several uses for life insurance in financial planning for a wealthy individual. Before discussing them, let’s start with a discussion of how life insurance is structured.

Types of Insurance

life insurance types

life insurance types

Life insurance comes in two basic forms: “temporary insurance,” also known as term insurance, and “permanent insurance,” which comes in several varieties—whole life, universal life, equity-indexed universal life, and variable universal life.

Temporary or term insurance derives its name from the assumption that the insurance will only be needed for a limited period.

The most effective form of temporary insurance is level premium term insurance which typically comes in 5, 10, 15, 20, and 30-year durations.

In the years following the end of the level period, the premiums increase substantially.

In most cases, the policy will be convertible to a plan of permanent insurance with that company without having to provide medical or other evidence of current insurability.

Permanent insurance, as the name suggests, is for a long-term need.

Long-term could be defined as the point where, economically, it is more advantageous to have purchased permanent insurance.

The crossover point is determined by comparing the term insurance premium with the permanent insurance premium and investing the difference in a “side fund” at a rate of return equal to the assumed earnings rate within the permanent policy, less applicable income tax.

Te crossover normally occurs between the 15th and 20th years. So if the projected need exceeds that, permanent insurance would generally be more appropriate.

Also, term insurance is generally not available significantly beyond life expectancy, the point where 50% of the insured population is deceased and the other 50% survives.

Therefore, permanent insurance may be the only practical solution for long-term needs, such as for the payment of estate tax.

The basic difference between term and permanent insurance is that with permanent insurance the initial premium is higher than the insurer’s mortality and other costs.

With the difference allocated to a cash value fund from which future charges will automatically be withdrawn when the current premium is no longer sufficient to cover them.

The advantage of this arrangement, overlooked by many, is that cash values grow tax-deferred as long as the policy remains in force.

Therefore, the insurance costs are paid from untaxed earnings within the policy (i.e., pre-tax).

The proof of this is that if a life insurance policy is surrendered, the gain (taxed as ordinary income) is determined after subtracting the premiums paid (which constitute the policyholder’s basis) from the cash value.

In effect, the cost of the insurance charges reduces or perhaps eliminates the taxable gain.

This arrangement allows for a manageable insurance premium throughout an individual’s life, no matter how long he or she lives—permanent coverage.

As mentioned earlier, permanent insurance comes in four different versions: whole life, universal life, equity-indexed universal life, and variable universal life.

The primary distinction is in premium payment and cash value investment flexibility.

A whole life insurance premium is generally fixed, although it may be possible through the addition of certain “riders” to lower or raise the base premium.

In contrast, with universal, indexed, and variable universal life insurance, the policyholder has premium payment flexibility to start with a low or high premium, skip and resume premiums (although, at the risk of a “lapse” in coverage if insufficient premiums are paid).

As to investment flexibility, both whole life and universal life cash values are invested conservatively by the insurance company, generally in bonds and mortgages.

However, in the case of equity-indexed universal life, the credited rate is tied to the change in the value of a stated index, typically the S&P 500 (an index of approximately 500 large U.S. exchange-traded companies), with a minimum rate of 0% or 1% to protect against years when the S&P 500 experiences a loss.

In contrast, variable universal life insurance cash value is invested at the discretion of the policyholder in a variety of investment subaccounts resembling mutual funds.

Take a Look:   How Much Life Insurance Do I Need? 2021 Update

It is not unusual for an insurance company to offer 70, 80, or more different subaccounts representing most sectors within the stock and bond markets, domestic and international.

This allows the policyholder the opportunity to capture potentially higher returns than that available with whole life or universal life policy, although with an accompanying increase in risk.

Should the investments underperform over an extended period, there could be insufficient funds to sustain the policy and the policy would therefore lapse.

Both universal and variable universal life policies are available with a no-lapse feature—guaranteeing against a policy lapse if a specific “no lapse” premium is paid.

Of course, these and other features entail a charge, whether explicitly stated or inherent in the policy’s cost structure.

Because future interest credits or investment returns are unknown, periodic re-illustrations must be obtained for existing policies.

Such “point-in-time” or “in-force ledger” illustrations will take into consideration existing cash values as well as future planned premiums, earnings, and expense assumptions to forecast policy performance.

Such illustrations may reveal that the premium should be changed (increased or decreased) to sustain the policy as originally designed.

Life Insurance Policy Taxation

As an acknowledgment of its “social good,” life insurance death benefits are generally received income tax-free.

And, as previously stated, cash value build-up within a permanent policy is tax-deferred as long as the policy remains in force and may be withdrawn on a tax-favored basis.

There are, however, exceptions to the aforementioned tax treatment. Death benefits may become taxable if policy ownership is changed in a so-called “transfer for value” transaction.

Additionally, cash values may become taxable upon withdrawal if “guideline premium” limits are exceeded, and cash value build-up may be currently taxable under certain corporate ownership scenarios. federal estate taxation, if certain “incidents of ownership” were retained.

Hence life insurance policies intended to provide liquidity for estate tax payment should not be owned by the insured, but rather by a third party, such as an irrevocable trust for the benefit of the insured’s beneficiaries.

Finally, an unintended taxable gift can result in a three-party transaction—where the insured, owner, and beneficiaries are different individuals or entities.

So, needless to say, care should be taken as to ownership and beneficiary arrangements and ongoing policy monitoring.

Ways to Pay Estate Tax

So, with that by way of background, let’s turn to some specific uses in estate and business succession planning for the wealthy individual. Perhaps the most common is to pay estate taxes.

Even for those whose estate would not currently encounter an estate tax, if over their lifetime their estate is projected to grow to a greater amount than the inflation-adjusted exemption, estate taxes will be an issue.

One could take the position “I don’t care about the estate tax. It will be my kids’ problem.

” But most people do care; they worked hard to accumulate wealth and they would like to preserve it. The fact that you’re reading these words suggests that you are one of them.

In reality, most people don’t maintain the equivalent of 40% of their estate in cash to pay the estate tax because of the opportunity costs—what you could earn on it if deployed to better use (i.e., invested). So that option is moot.

But even if that was the method of choice, it is not the cheapest.

Lacking cash, the executor would look to sell assets. Given that the estate tax return and the tax are generally due in nine months, that’s not a lot of time to sell real estate and business assets.

We’ve all heard of an estate sale and the notion it conjures up—a bargain! So it is not unlikely that assets are sold at discounted prices. Market conditions at the time of death can exacerbate matters.

Asset prices, be they bonds, stocks, real estate, or a closely held business, are governed by the same valuation principles: discounted cash flow.

So if cash flows and profits are reduced by poor market conditions and the discount rate is inflated by high inflation expectations or risk premium, the price is reduced.

I’m thinking interest rates of 20% in the 1980s, courtesy of Fed Chairman Paul Volcker, whose mission it was to break the back of stubbornly high inflation; real estate after the Savings & Loan crisis of the late 80s/early 90s; stocks after the dot com bubble burst in 2000; and all asset prices following the financial crisis of 2007–2008.

Take a Look:   What Does Life Insurance Cover? Here is 5 Thing

Borrowing against an asset, whether it’s a margin loan on marketable securities, a mortgage, or leveraging up a company’s balance sheet, is an alternative that could be used in conjunction with available cash and asset sale.

But it too has the effect of increasing the cost.

Because interest must be paid on top of the principal. That may be acceptable if the estate’s assets could earn a return sufficient to cover it.

But it has the effect of “leveraging up” the estate, which is precisely the opposite of what most individuals do at a certain point—de-risking the estate, paying down mortgages, eliminating cross-collateralization, etc.

Re-leveraging the estate for the next generation by an amount of up to 40% of its value may not be a desirable outcome.

A counterargument could be that the discounted value at which an asset is sold, not a higher value, is its value for the federal estate tax, eliminating the problem of selling at a discount. Mitigate, yes. Eliminate, no.

If we assume an asset, originally valued at $10 million, declines to $8 million, the resulting estate tax at 40% would be $3.2 versus $4 million, an $800,000 reduction.

But this still represents a loss of family wealth of $1.2 million ($2.0 million–$800,000).

The Economics of Life Insurance

The Economics of Life Insurance

The Economics of Life Insurance

The Economics of Life Insurance So let’s turn to life insurance.

Depending upon age, state of health, whether an individual or joint-life/second-to-die policy, and universal, indexed, or variable universal life policy is used, life insurance may represent a significantly less expensive approach when the premium, paid through life expectancy, is compared to the death benefit, as indicated in Table 6.1. So for a 60-year-old male.

Life insurance represents a 70% reduction (37.6¢ versus $1.25 per dollar) in the cost compared to the likely alternatives: liquidation, or borrowing. For a survivorship policy, the reduction is about 75% (30.2¢ versus $1.25 per dollar).

So from this analysis, one could conclude, “I don’t have to ‘believe’ in life insurance. I can see that mathematically it makes sense.

But, instead of paying an insurance premium, what if I had invested the money?

In answering that question, you first need to answer the question of “invest in what?” To achieve “an apples-to-apples” comparison, the investment alternative must share the same attributes as life insurance.

Namely: be liquid (death benefit is payable in cash from policy inception), safe (insurance can provide a guaranteed death benefit backed by the insurer’s financial strength), and income tax-free (under federal and state law).

So that eliminates illiquid, non-guaranteed assets, such as real estate, stocks, and closely-held businesses from the comparison. That pretty much leaves tax-free municipal bonds which at the time of this writing are yielding about 2.5%.

Compare that to a return of 8.15% for the 60-year-old couple, representing the return on the premiums paid through their joint life expectancy.

This is a taxable equivalent of 10.87% in a 25% combined federal and state bracket.

Comparable results are achieved with other ages as well. As previously stated, results vary with age, gender, condition of health, and type of policy.

In addition to comparing life insurance with other non-comparable asset classes, other factors are often also ignored in the analysis.

One is leverage. Leverage, as everyone knows, magnifies returns as well as risks. Life insurance can be levered also. It’s called premium financing.

Banks and premium finance companies routinely finance insurance premiums, using the cash value, death benefits, and possibly other assets as security.

Loan interest rates are usually a stated percent margin over London Interbank Offered Rate (LIBOR) or another index. Premium financing has the effect of enhancing the insurance IRR as it would any other asset.

And one final mix-comparison is in failing to acknowledge that a portion of the return on an asset is compared with life insurance is owing to the labor and expertise contributed by an active real estate investor or entrepreneur.

Life insurance requires no such labor: You pay the premium, and the insurance company does all the work.

So, to sum up, does a wealthy person need life insurance? Of course not.

It’s the children’s problem, and they can always liquidate or leverage up assets.

But, if the question is posed as should a wealthy person consider life insurance, the answer is often “yes,” because of the compelling economics.

Life insurance is often thought of as its asset class, possessing unique risk and return attributes.

And as such, it should be carefully considered in structuring a comprehensive estate plan.

About the author

Garcia Olivia

I'm an internet geek, I like blogging especially about insurance, I worked before as an online insurance consultant, and now, I have insurancily.

Insurancily | Life Insurance Guide, Tips, Policies and More