Life Insurance Planning

March 4, 2009

Rande Spiegelman
CPA, CFP®, Vice President of Financial Planning, Schwab Center for Financial Research

Risk management planning typically includes a comprehensive review and analysis of all insurance coverage needs:

• Property and casualty (auto, home, etc.) 
• Additional personal and professional liability 
• Medical and dental 
• Long-term care 
• Disability
• Life

Here, we specifically address the life insurance component of risk management.

Generally, we believe that you should purchase life insurance only when you have large liabilities that will continue after your death for which you are unable to "self insure" with existing assets. When considering the role of life insurance as part of your overall financial plan, first consider the following:

• It could be that you don't actually need life insurance (e.g., no dependents, few liabilities, retired with no income replacement need, no illiquid assets subject to estate tax, etc.). 
• Using costly insurance contracts primarily as investment vehicles (e.g., whole life, cash value policies) is generally inferior to purchasing low-cost, term life policies and investing the difference yourself. 
• Take advantage of employer policies, but secure outside coverage if the policy is not transferable and life insurance is needed.

Determining life insurance needs involves an analysis of the potential financial burdens created by the death of an individual. Such financial burdens could involve the need to meet immediate one-time obligations and/or provide a financial asset base to meet ongoing cash flow needs.

Life insurance could also play a role in estate planning, either as a wealth-replacement vehicle or to provide liquidity in meeting estate tax liabilities when illiquid assets represent a significant portion of the estate (family business, real estate, farm, etc.).

Finally, life insurance can be a critical component in business planning. The appropriate type of life insurance will largely depend on the facts and circumstances surrounding the need. There are a wide variety of life insurance products on the market today, too many to discuss in great detail here, but there are a few primary types:

• Term life insurance. Term life insurance is pure life insurance for a specific period of time and pays benefits only if the insured dies before the term expires. The primary advantages of term insurance are lower costs, a high degree of control and flexibility. Since policyholders are only paying for the pure insurance component, they could invest the difference between the cost of a term policy and a whole life policy as they see fit. There is a greater degree of control in that the insured can opt to only maintain coverage for a set period of time, up to the point, for example, where life insurance may no longer be necessary (e.g., when the individual is "self-insured" through his/her asset base).  
  
  Term insurance may offer greater flexibility with such features as automatic renewal and/or a provision for conversion to whole life. While term insurance provides the most insurance coverage per dollar spent, it does not provide any cash value buildup or permanence, and can be expensive in the later years of life or if health problems develop prior to subsequent renewal.
   
  
• Whole life insurance. Whole-life insurance premiums are higher than those for term insurance because they include both a portion for the pure insurance component and a portion allocated to savings or investment. Imbedded commissions tend to be higher with whole life policies, as well, which means cash value tends to build up slowly in the early years of the policy. One advantage of whole life insurance is the ability to accumulate cash value on a tax-deferred basis, value that could be borrowed against or applied to future premiums.
  
  Whole life insurance is also "permanent," which may be advantageous should the policyholder develop subsequent chronic health problems or if continued coverage is desirable in the later years of life, particularly where estate planning is an issue.
   
  
• Universal life insurance. A hybrid policy that provides flexibility in premium structure and includes the separate protection of conventional term insurance with a fixed cash-equivalent savings component (the insurance company takes the risk for cash value buildup).
• Variable universal life insurance. Similar to universal life, but with flexible owner-directed investment options for the cash value component of the policy (the policy owner takes the risk for cash value buildup).

Assessing the need for life insurance

When assessing your individual situation, consider immediate capital needs and ongoing income replacement:

• Immediate capital needs. Final medical costs, funeral and burial expenses, settlement of short-term debts (could include mortgage), college expenses, etc.
• Ongoing income replacement. Providing a sufficient financial asset base to replace lost income through ongoing cash flow. For example, if the goal is to generate $50,000 for a period of 30 years (adjusted for inflation) with a high degree of confidence the money will last, then according to the 4% rule you would want a portfolio of $1.25 million. This would be in addition to the amount needed to fund immediate needs at death.

Immediate capital needs are combined with the amount needed to fund ongoing income replacement to arrive at the total financial need. Existing financial assets can then be subtracted from the total need to arrive at the total amount of life insurance coverage required. Finally, other life insurance coverage, such as employer-provided life insurance, would then be subtracted to arrive at the net amount of additional life insurance needed. See the table below for a sample breakdown of life insurance needs.

Other uses of life insurance

• Estate preservation and liquidity. Charitably minded individuals may seek to lower their taxable estates by leaving a significant portion of their estates to charity while still providing for their heirs. In such cases, life insurance could provide the desired wealth replacement.
  
  • Other estates may consist primarily of illiquid assets (such as a family business or farm), or significant real estate holdings, in which case survivors could be faced with a "fire sale" to pay required taxes, expenses, fees and debts. Life insurance could provide needed liquidity for such estates. A commonly used type of life insurance for estate planning purposes is the so-called "second-to-die" or "survivorship" policy. A survivorship policy covers two lives, but pays out to the non-spousal beneficiaries on the second spouse's death. Because premiums are based on joint life expectancy, they are typically lower than they would be for a single life.
    
  A note on life insurance and taxes. Life insurance proceeds are not taxable to the beneficiaries for income tax purposes. However, the value of life insurance proceeds are includable in the gross estate (subject to estate tax) if the
  decedent retains any incidents of ownership on the policy at death (or makes a transfer of ownership within three years of death). A common planning tool to avoid estate taxation of life insurance proceeds is the "irrevocable life insurance trust" (ILIT). With an ILIT, a trust irrevocably owns the policy and the proceeds are kept outside of the individual's taxable estate (as long as the trust purchases the policy or the original owner lives at least three years after transferring an existing policy into the trust). Clients should always consult with a professional estate planner on all trust matters.
  
  
• Business uses of life insurance. Life insurance serves a variety of important business needs. (Note: Be sure to consult with your CPA and attorney to confirm such arrangements fully comply with the most recent IRS rules and regulations.)
  
  • Employee life insurance: Group life insurance is a basic component of employee benefit packages at all levels. "Split dollar" life insurance arrangements are sometimes made available as a special fringe benefit to key employees. In a split dollar arrangement, the employee and employer share the costs and benefits of the life insurance. Typically, the employer pays part or all of the premium and although there is no current deduction, the employer recovers the premium outlay upon the death of the employee. 
  • Corporate-owned life insurance (COLI): Special "key person" life insurance can help protect a business against the economic loss associated with the death of persons in key management or leadership positions. 
  • Business credit life insurance: Small businesses, particularly new or expanding small businesses, may find it easier to obtain credit through the use of business credit life insurance on the owner's life. 
  • Business succession: Life insurance can play a critical role in the funding of buy-sell agreements.

Summary table