Life insurance includes financial security strategies like estate planning, retirement funding, business succession, and debt coverage. These strategies contribute to various life insurance policies and must be planned wisely to maximize their benefits and minimize their tax impacts.
Estate Planning
Life insurance can be a significant tool in estate planning, assisting beneficiaries with final expenses, estate taxes and legacies. Term life insurance offers coverage for a specified period and is a cost-effective means of covering an estate until a certain age or financial goal is reached. Permanent life insurance plans, like whole or universal life, offer coverage that lasts as long as the policyholder lives and a savings element, which accrues cash value over time.
This ensures coverage for estate taxes and final expenses regardless of death. If an Irrevocable Life Insurance Trust (ILIT) is used with life insurance, the payout from the life insurance does not have to be subject to estate taxes.
Retirement Planning
Whole and universal life policies are a type of permanent life insurance, known to build cash value that can be laundered into income during retirement. Policyholders are entitled to withdraw from, or take loans against, the cash value, allowing them to use the money to supplement retirement income or pay for expenses.
Cash value grows tax-deferred, and withdrawals are generally tax-free up to the amount of the premiums paid. But remember that life insurance for retirement should be used in addition to other retirement savings like 401(k)s or IRAs and should not be the only source of retirement income.
Business Succession Planning
Life insurance is an integral part of business succession planning, as the funds from the policy can facilitate the needs of a buy-sell agreement and enable the owner to transition ownership smoothly. A buy-sell agreement, funded with life insurance, lets the remaining owners buy the deceased owner’s share of the business, maintaining continuity and stability.
In summary, key person insurance provides a business with protection from the revenue loss that accompanies the departure of a key employee or top performer. Life insurance can also help level the playing field among heirs, enabling a business to be passed down to one heir while providing equivalent value to others through the life insurance payout.
Debt Protection through Life Insurance
Some people also use life insurance to pay off debt. The death benefit may be used to pay off mortgages, credit card debts, personal loans, and business debts. Term life insurance can be adequate for covering debts with a fixed repayment period, while permanent life insurance can provide lifetime coverage. Determining whether the debt is inherited and coordinating the policy with estate planning documents are important.
Using Life Insurance as a Vehicle for Charitable Giving
Life Insurance as a Tool for Charitable Giving Life insurance can be one of the most powerful tools in your giving arsenal. It allows your clients to make a bigger impact than they may be able to afford through an outright gift. Donors can name a charity as the beneficiary of a life insurance policy and provide a large gift upon their death.
A more straightforward option available during life is to donate a life insurance policy to charity, which can also provide a current-year income tax deduction. Life insurance can also be used along with wealth replacement trusts for charitable purposes to fund a cause and ensure a family’s financial needs are met.
Tax Consequences of Life Insurance Solutions
Knowing the life insurance techniques is vital for getting the best out of them. Generally speaking, life insurance proceeds paid out upon the insured person’s death are exempt from income tax. Of course, exceptions include interest received on installments paid or if the death benefit is included in a taxable estate. If a policy loan is not repaid, it can reduce the death benefit, and if a policy lapses with an outstanding loan, it can create taxable income.
Potential Dangers of Using Life Insurance for Retirement Income
The risks of relying on life insurance for retirement income include high insurance costs that reduce cash flow, the potential for reduction in death benefit, the risk of the market (with variable life policies) and the chance of policy lapses due to unpaid premiums. Understanding these risks is a pivotal step in making one consider life insurance more of a supplemental tool to traditional retirement savings plans rather than a one-size-fits-all solution.
High Expenses and Lower Cash Flow
Permanent insurance premiums cost significantly more than term insurance, and you pay upfront, limiting your cash flow and savings potential. Because coverage is lifelong and includes the potential to build cash value, premiums for permanent life insurance can be more expensive.
A large percentage of premiums during the initial years will be spent on insurance and administrative costs, resulting in the cash value building very slowly. Hence, relying on life insurance exclusively for retirement cash flow might be less effective than alternative retirement investments.
Impact on Death Benefit
Having to withdraw too much cash value from a life insurance policy during retirement can lower the death benefit. Policyholders need to consider the immediate advantages of accessing the cash value against the possible future effects on the death benefit and whether accessing it now would negatively impact the protection for the family. If the withdrawals exceed what was paid in premiums, the excess — which is the policyholder’s gain — will also be taxed at their ordinary income tax rate up to the basis of the constructive receipt of policy gains.
Market and Lapse Risks
Variable Universal Life (VUL) insurance policies permit the cash value growth to be invested in sub-accounts, comparable to mutual funds, leaving the policyholder open to market fluctuations that can generate high returns but may also lead to large losses. The return on cash value in VUL plans is unbounded and can end up causing policy holders to lose money.
If investments fall flat, premium payment works may need to increase to cover the cost of insurance and to rebuild the cash value or risk the policy’s lapse, and the loss of insurance protection. A policy can also lapse if loan amounts are sufficiently high.
Tax Implications
The cash value grows tax-deferred inside a life insurance policy, and policyholders can withdraw tax-free amounts up to their premiums total. But any gains, including dividends, are taxed at ordinary rates. Policy loans reduce the death benefit if they aren’t repaid, and, if one lapses with an outstanding loan, can create taxable income.
The multifaceted nature of life insurance provides multiple avenues to fortify your financial framework through estate planning strategies, retirement funding, continuity of business operations, debt coverage, and charitable endeavors. As is the case with all insurance products, selecting the right policy and integrating it into an overall financial plan are critical to maximizing its value.
Selecting the appropriate type of life insurance coverage — instant, term, whole life or universal life — is a highly personal decision and should align with each individual’s financial goals and risk tolerance. Use of life insurance as a source of retirement resources is an inherently high-risk, not to mention expensive, proposition that is subject to market fluctuations.
Accordingly, it might be beneficial to discuss with appropriate financial and tax professionals the degree to which the various nuances of life insurance strategies may fit into an overall plan for financial security. This brings it all together in a tax-wise manner that could work out better than others, reaping the most benefits while setting up as little tax consequences as possible.
Other Resources
• Consumer Financial Protection Bureau
• Investopedia: Life Insurance Strategies
See also
How Much Life Insurance Coverage Do You Need?