Exploring the Versatility of Life Insurance: Ways You Can Use Your Policy
Life insurance is a valuable tool when properly utilized. Because there are so many variations and types available, it's prudent for the shopper to research viable options and to talk with someone who can help address questions. Life insurance's most common and simplistic purpose is to replace lost income and resources for the heirs of someone who has died. But it's not just about this. Life insurance is a versatile tool that can meet a variety of needs. In this post, I will discuss lesser-known purposes to the everyday person. Often, because we are unaware of the options, we can miss out on opportunities. This educational opportunity (ed-op) will help you graduate with a higher level of understanding and a sense of empowerment in managing your finances.
1. Living Benefits (insured). Life insurance doesn't need to be useful for beneficiaries. Many policies offer living benefits, which allow the insured individual to access money to cover expenses related to their critical or terminal illness. These expenses could include medical bills, home modifications for disability, or personal care services. Monies taken decrease the death benefit; however, this padded store of resources is helpful, especially for those who do not have a long-term care (LTC) plan or only have Medicare, which does not cover extended assisted living services.
2. Cash Value Loans & Withdrawals (whole life). Social media influencers often post videos declaring you can use life insurance to 'be your own bank!' These assertions are valid, though there is more to the story. Permanent (whole life) policies provide the policy owner access to cash value that can be withdrawn (generally trips tax penalties) or taken as a loan from the policy once an adequate reserve is established. This 'adequate reserve' is what we call 'frontloading'- it means that a significant amount of money needs to be paid into the policy upfront. Loans are paid back to the policy owner at a low interest rate, payment plans are often flexible, and no credit check or application is needed to explain the reason for taking a loan against the policy. The loan feature does resemble a bank! One caveat is the policy owner can only withdraw monies for the requisite amount that has been paid into the policy, which often means premiums will have to be paid for at least a few years before the policy owner can access the cash value. Additionally, enough will need to be paid (or frontloaded) into the policy to have enough money to borrow. For instance, if you've had a $500K whole life policy and your monthly premium is around $275, by Year 5 of paying premiums, you will likely have less than $10K available in cash value.
3. Lifetime Income (annuities). Annuities are not your typical life insurance policy. Annuities are a good option when you want a regular check guaranteed for life, much like a pension. Unlike life insurance, which pays a lump sum death benefit when the insured dies, annuities pay a fixed amount. While you are alive, annuities hedge against the possibility of living too long to outlast your savings. Annuities require that you frontload a sizable amount of money to establish the life insurance policy, so this is generally utilized by the more affluent individual or those with significant 401(k)/403(b)/TSP retirement funds that can be transferred (often penalty-free) and used to create an annuity policy.
4. Tax Efficiency. Absent any exclusions to federal taxation of an insured individual's estate when a trust is involved, the death payment on life insurance policies paid to beneficiaries is tax-free.
5. Trust Funding. Trusts are estate planning vehicles typically used for tax savings and probate avoidance/ease to distribute assets owned by the settlor (person who executed the trust) to beneficiaries at their death. There are several types of trusts, some offering tax savings, some not, but once the trust is created, assets must be transferred to it at some point, during the settlor's lifetime (inter vivos) or at their death (testamentary). This writing focuses on the general use of life insurance to fund a revocable/irrevocable trust. Life insurance is very efficient in that the insured transfers policies to the trust, or the trust purchases new policies on the insured's life to provide for its beneficiaries. Consult an estate tax attorney for what works best for your unique circumstances.
6. Loan Collateral. Some loans are significant enough to require collateral if the debtor cannot repay them due to an untimely death. In these situations, the lender may require the debtor to secure a term life insurance policy for the loan term's duration in the debt amount. For example, a contractor completing a major remodel for a homeowner that will span over several years and cost $100K may ask the contract for services to be supplemented by a term life insurance policy.
7. Business Partnerships. Many partners enter a business together without thinking about what would happen if one unexpectedly dies. Savvy partners with lucrative business ventures often secure life insurance policies on one another (cross-policy, meaning each partner is the beneficiary of the other's policy) to cover one-half of the valuation of the business. In the event a partner dies or becomes permanently disabled and unable to fulfill their obligations to the business, the surviving partner can continue operating or, if needed, buy out or sell to an inherited partner (typically, the deceased partner's spouse), which is termed Buy-Sell Funding.
8. Business Protection. When businesses want to reduce their risks of a single-pointed failure, they get creative to use life insurance to protect their investment in an individual critical to its success. With Key Person coverage, an employee is typically the "secret sauce" of the business, and if they were to become unable to contribute to the business unexpectedly, it might fail; the employer secures a life insurance policy, pays for it, and is the beneficiary, and uses the proceeds to offset any financial setbacks or efforts to replace the key person.
9. Executive Bonus Plans. These bonuses in the form of life insurance policies are employer-paid for the employee who owns the policy. During their lifetime, the employee may utilize the cash value, living benefits, and other aspects of the policy if offered. At the employee's death, beneficiaries it named receive the tax-free proceeds.
As with any decision to purchase life insurance, diligently research and discuss your goals and needs with a licensed insurance agent. Consider meeting with an estate tax attorney and a certified public accountant (CPA) for estate tax and tax mitigation advice.
