Everybody knows the basic idea of life insurance: Wage-earners spend a little bit each month to make sure that, if anything happens to them, their families can enjoy some degree of financial security. But what about affluent clients who are already financially secure? Do they have any use for life insurance?
For many well-to-do people, the answer is yes, experts say.
"Financial advisors tend to see life insurance as a potentially important long-term investment for their clients," says Michael A. Mingolelli, the CEO of Pinnacle Financial Group, an insurance and benefits consulting firm in Southborough, Mass.
"Generally speaking, it has three major advantages over many other types of investments: certainty, liquidity and favorable tax treatment."
Classic life insurance is a certain investment because of the death benefit (variable life insurance is less certain). Unlike equities, heavily regulated life insurance is guaranteed to pay out eventually, assuming you pay the premiums-an advantage that might not have sounded important a few years ago, but which is likely appreciated by those looking at their equity portfolio statements today.
The real question is not if classic life insurance will grow in value and pay out, but when and how much. Somewhat perversely, the sooner the insured person dies, the better the return on the investment. This is true even for the type of life insurance policies that tend to be used as an investment, namely "permanent" life insurance policies, which require the holders to pay relatively high premiums when the insured is young. Part of these premiums then becomes "cash value," which is eventually used to keep premiums in check when the person grows older (and would otherwise increase substantially). These internal cash values grow tax-free over the life of the policy and continue to remain free of income tax unless the owner makes substantial withdrawals during his life.
Life insurance is liquid because of the insurance company's obligation to pay the proceeds as soon as the claim is filed and because it generally avoids probate. Liquidity is an advantage in any environment, since cash can immediately buy things, and people in need of it otherwise have to sell assets for less-than-reasonable prices. And liquidity is a particularly great advantage for an estate. Without it, heirs are stuck trying to pay estate taxes by selling off substantial amounts of property, sometimes in a fire sale, since much of the decedent's wealth is likely not in cash but in stocks, bonds, real estate or other illiquid items. So having life insurance proceeds available to fund the purchase of these assets and then pay estate expenses can mean significant savings.
An inflow of insurance proceeds can also be quite useful to family-owned businesses. "It is not uncommon for parents to take one or two of their children into the business while the others pursue alternative careers," says Robert Morrill, an estate planner with Gilmore, Rees & Carlson P.C. in Wellesley, Mass. "The parents want to treat all their kids equally, but they don't think it is a good idea for some of their kids to own a big chunk of a business they don't know much about." These parents may have all their wealth tied up in their businesses, so they don't have enough assets for even distributions to the kids. If they use a life insurance component, however, they have a stream of cash to keep the estate distributions even.
Business owners overseeing closely held companies may also need liquidity to pass the business on to surviving partners. Even though a business owner may work well with his partner, he may not want to give that partner's heirs a say in the company when the partner dies. Instead, he can make an arrangement giving partners or fellow stockholders the right to purchase a deceased co-owner's share. In this strategy, either the company or the co-owners purchase a life insurance policy on every owner. If one of them dies, the surviving partner or partners become the sole owners and the deceased partner's heirs get paid for the value of their interest with life insurance proceeds. The biggest problem is valuing the shares, which can sometimes be difficult to do in a closely held company.
Since lawmakers consider insurance a hedge against catastrophic loss rather than an investment, it has tax advantages. That means all the cash value accumulated in a permanent life insurance policy grows free of income tax-even the cash in those policies that depart from the classic model and instead serve as a "wrapper" for equity investments.
"Wrapping can be especially useful for wealthy individuals who are involved in hedge funds," says Mingolelli, "because short-term trades don't benefit from low capital-gains rates."
In many cases, life insurance can also be passed on free from estate tax. In 2010 only, there is no federal estate tax since Congress has temporarily killed it (it is slated to return in 2011). Those who want to avoid it in the future, however, might set up a special life insurance trust with someone else as trustee and give the trust an insurance policy. Since the buyer no longer owns the policy, it isn't included in his estate, yet the proceeds can still be distributed tax-free.
Life insurance also helps those who want to make very large gifts during their lifetime, since such transfers are subject to a gift tax. One of the advantages of a life insurance trust is that it tends to accumulate cash value over a pretty long period of time-the life of the insured. If properly drafted, a life insurance trust can benefit from an annual contribution of $13,000 for each beneficiary without being subject to gift tax. Those annual contributions can grow tax free and eventually become a pretty significant life insurance policy whose proceeds can be passed on without being subject to income taxes, estate taxes or gift taxes. The key is to start young enough.
Even if you do make very large contributions to a life insurance trust-most likely because you are making contributions later in life-the gift tax will often not be too great. First of all, the amount of the gift isn't the amount the policy will ultimately pay out when the insured dies, but rather the amount needed to pay the premium for a particular term, which is much lower.
Second, the gift tax can be reduced by some intricate planning techniques. For example, say instead of paying a gift tax yourself, you loan the money to your life insurance trust to do it for you. In ordinary times, that wouldn't be the best idea, since you wouldn't want the trust to have to make big interest payments, and interest-free loans are strictly limited under the tax code. But with interest rates these days at rock bottom, you could loan money to your trust almost for free. You could also simply loan the insurance trust the money to purchase the policy outright, which would avoid gift tax altogether, but would of course require a much larger and ultimately costlier loan.
Such benefits can make life insurance a crucial part of estate planning. But what about its use in the short term?
Here, the benefits are a bit more debatable. One of the advantages of life insurance is that you can still indirectly access the policy's value even after you have formally given it away to the trust. This is because the trustee can always borrow against the cash value of the policy and then loan you the money. If you don't pay the money back, then the depleted cash value may not be sufficient to pay the full premiums on the policy in later years, which ultimately means a lower payout. On the other hand, individuals setting up life insurance trusts can take a certain level of comfort in knowing that the money is there during their lives if they absolutely need it, which is not the case for many estate planning techniques.
Moreover, if they so choose, investors can accumulate much more cash value than they actually need, because typically insurance companies don't object to the "overfunding" of policies. Some experts consider this a worthwhile investing technique because it avoids income taxes, but others aren't so sure.
"Yes, overfunding a life insurance policy can avoid income taxes," says Jonathan Forster, a shareholder in the Tysons Corner, Va., office of Greenberg Traurig LLP. "But there are other forms of financial planning that are far less cumbersome and don't involve the charges insurance companies impose."
Regardless, it is the rare estate plan that doesn't use a life insurance component. With the estate tax set to return to 55% in 2011, any well-to-do investor would be well served to look into a life insurance policy for the long haul.