By Richard A. McGrath, CIC, LIA
The reason for buying life insurance, of course, is to protect your family. But it can also be used to protect your business, transfer wealth from one generation to another, provide retirement income and serve as a source of financing.
Like any insurance policy, life insurance should be purchased for the protection it provides; if you’re looking for an investment, for example, you can likely find more profitable ways to invest your money. However, life insurance is perhaps the most versatile form of insurance and can serve many purposes relating to its value as insurance.
The most basic reason to have life insurance is to replace your income in case tragedy strikes. The “death benefit” it provides can allow remaining family members to continue living in their current lifestyle.
You may have other goals, too, that life insurance can help you accomplish, such as:
Transferring wealth. The death benefit from life insurance is subject to federal estate taxes, but not to federal income taxes. Transferring ownership of the policy to a trust or buying a new policy for a trust can make it exempt from estate taxes, too. Given that estate taxes are scheduled to return to a top rate of 55% in 2011, that’s an important advantage. Currently, assets valued at up to $3.5 million are exempt from estate taxes, but the exemption is scheduled to drop back to $1 million in assets in 2011, unless Congress takes action before then.
When the insured dies, the death benefit can remain in the trust and provide income to a surviving spouse or to other heirs. Income from the trust is not part of the spouse’s estate for tax purposes.
It is important to know, though, that a life insurance trust is irrevocable. The trust will own the policy permanently, and you will not be able to change the beneficiary, cancel the policy, borrow against it or otherwise alter it. Also, if you transfer an existing policy into the trust rather than establishing a new trust-owned policy, it will be subject to estate taxes if you die within three years.
Passing on ownership of a business interest. When a business has multiple owners and one dies, the remaining owners typically need to find a way to buy the portion of the business owned by the deceased owner.
Using cash to purchase the business interest of the deceased is typically not an option; few businesses generate enough cash to make such a purchase without putting a financial strain on the business. Instead, owners can purchase life insurance policies on each other and use the death benefit to buy out the interest of the deceased partner.
Business owners may even purchase a special policy called first-to-die insurance, which, despite its gloomy name, is an attractive product, because it can cover multiple lives with a single policy. For example, if a business has two owners and one dies, the death benefit will go to the other owner to pay surviving heirs for the business interest of the deceased.
A buy-sell agreement is typically established to guarantee that when an owner dies, the surviving owners will purchase the deceased owner’s share of the business at a fair-market price.
When an owner retires, the cash value of the life insurance can also be used to purchase the retiring owner’s share of the business. Life insurance can provide a variety of methods to prepare for either the death or retirement of an owner without having a financial impact on the business.
Generating retirement income. While life insurance is not the best way to generate retirement income for most people, it is often used by executives to fund a “split-dollar plan.” Typically, the employer advances funds to the executive to pay premiums on a cash-value life insurance policy. The employer is a beneficiary of the policy.
The employer may receive money back from the death benefit when the executive dies or from the surrender value of the policy when the employee retires. The remaining funds can provide income for the executive or a benefit for the executive’s family.
Split-dollar plans are subject to complex federal regulation. Experienced legal, tax and insurance advisors should be consulted when establishing a split-dollar plan.
Borrowing. Depending on the policy, loans and partial withdrawals typically can be made on up to 80 percent of the surrender value of a cash-value life insurance policy, minus any outstanding loans and surrender charges, depending on the policy. However, loans and withdrawals may be subject to interest charges and withdrawals may be subject to partial withdrawal charges and fees. Loans and withdrawals will also reduce the policy’s cash value and death benefit.
Loans can be made after the first year of the policy and can be repaid at any time during the life of the policy. Loans and accrued interest not repaid are subtracted from the death benefit and surrender value. As long as the policy is in force, loans are not subject to income tax.
Life insurance is versatile, but its more important role is to provide the protection you need for your family and your business.
Richard A. McGrath, CIC, LIA is President and CEO of McGrath Insurance Group, Inc. of Sturbridge, Mass. He can be reached at firstname.lastname@example.org.
This article is written for informational purposes only and should not be construed as providing legal advice.