Life Insurance for the Not-So-Silent Majority
Uses other than for estate planning.
Richard L. Harris | Mar 25, 2020
Almost every article published about life insurance in Trusts & Estates is focused on the ultra-high-net- worth (UHNW) individuals whose net worth exceeds $30 million. Those aren’t the majority of clients most of us see every day. It’s important to understand the uses of insurance for that majority. Some of these uses may also apply to UHNW clients, depending on their circumstances and concerns.
Whenever I meet someone for the first time and he asks me, “Why do I need life insurance?” I answer, “I don’t know if you do. Let’s talk.”1 (The real question is whether he wants life insurance.) Selfish people usually don’t buy life insurance. They don’t want to spend money on anything that doesn’t directly benefit themselves. Others don’t object to the insurance, only having to pay for it. Life insurance is a tool. People buy life insurance for what it does, which is to provide money at a time when it’s needed. People use their own values to determine if they want insurance, and if so, how much and what kind.
A Young Family
The most basic situation is that of a young family. Let’s consider a 35-year-old who’s married with two children. It could just as easily be that both spouses are breadwinners. If the individual lives long enough, he’ll have provided for the family needs (and wants), paid for two college educations, paid off a mortgage and set aside enough money for a comfortable retirement. There may be other debts. Assume that the family needs $5,000 per month to live, which will increase because of inflation. That’s $60,000 per year to start. It’s anticipated that college education for each child will cost $75,000 per year. They also have a $250,000 mortgage. With today’s low interest rates, it may be smarter to invest money than to pay off the mortgage. Some people prefer to live debt-free. Apart from that, one or both spouses are providing services such as childcare, housekeeping, shopping and transportation. Replacing those services will cost money. Even if one of the spouses has no income, the services she provides will be missed and have value. Insuring a non-working spouse is very important and often overlooked.
Depending on how they want to handle those issues and inflation, I would first recommend enough term insurance2 for an appropriate time period (such as until the children have finished college) to cover those items.3 Clients would determine the amount based on what needs they want covered and what they can afford. I would take into account any Social Security benefits the family would be entitled to as an offset. However, I would leave it to them to decide on the certainty that those benefits will be available and in what amount. With people changing jobs, I don’t know whether it’s appropriate to rely on whatever group insurance the individual has at the time. That’s the client’s call.
Leaving a Legacy
Some people want to leave a legacy for children or grandchildren. (The children are rotten, but the grandchildren are great.) Life insurance is an opportunity to guarantee a legacy using a properly structured permanent policy.4 Some people planned on leaving stretch individual retirement accounts as a legacy. With the passage of the Setting Every Community Up for Retirement Enhancement5 (SECURE) Act, stretch IRAs are gone. For more information, see our SECURE Act coverage, starting on p. 32 in this issue. A policy owned by a trust can provide the same benefits as a stretch IRA, without the same income tax consequences. In fact, the payout from a trust isn’t limited to a beneficiary’s lifetime as it was before in the stretch IRA.
It’s not uncommon to find clients with second families—children from more than one spouse. They can use life insurance to create benefits for any or all of the children, especially if some of the children won’t be inheriting the estate or will be inheriting less than they would have if circumstances had been different. If a second spouse is going to receive assets from the current spouse, the client can use the insurance to provide a similar amount to the children who otherwise would have received that inheritance. Fairness, like beauty, is in the eye of the beholder. It doesn’t mean treating everyone equally.
Many people like the savings feature of permanent life insurance—as long as they know it comes at a cost in the form of expenses inherent in providing a death benefit. Properly structured, the cash value of a policy can grow income tax deferred or free. If an individual needs insurance, the difference between term premiums and permanent premiums makes the permanent policy attractive. Going back to our young family, I would recommend permanent insurance to someone who can afford it and understands the benefits. Universal life policies offer the most flexibility in setting premium payments. Variable universal life policies offer the opportunity to invest in equities and debt through what are known as “subaccounts.” Equity indexed products can offer some stock market-like performance with minimal risk.6 An individual can access the cash value from any permanent policy (other than a guaranteed universal life—which is like term insurance), whether by withdrawal, loan or both. If done properly, it won’t trigger an income tax.7 As long as the insured dies with the policy still in force, there won’t be any income tax.
Clients with businesses have other needs for insurance. If there are two or more principals in the firm having some kind of buy-sell or redemption in place, life insurance is important for the continued viability of the business. It makes sure that the funds are there to fund the buyout without the business having to use its cash flow to pay out the deceased owner’s beneficiaries. The agreement also insures a (usually) harmonious transfer. Because someone’s interest is bought out, the surviving owner(s) doesn’t have to deal with family members of the deceased. The price and/or a formula to determine the price has been previously agreed on. Apart from life insurance, funding a disability buyout is equally as important.
The business may have a key person—one whose loss will result in economic loss to the business. Examples are sales people with personal relationships with accounts, inventors whose new products keep the business growing or executives who have specialized knowledge that isn’t readily replaced. That key person can be insured in favor of the business to offset the monetary effect of the loss of the individual.
Insurance can also be used to retain key people. A split-dollar arrangement can give the individual additional insurance at nominal cost. The cash value and/or death benefit can fund some form of supplemental retirement benefit. An incentive plan, such as a phantom stock plan using insurance, can be offered instead of equity in the business.
A family business may present other issues. Some of the family members are in the business, but others aren’t. The business is going to be left to those in the business. It may be that no interest of any kind is going to be left to those not in the business. In my experience, such circumstances are the rule rather than the exception. Insurance can be purchased on the owner for the benefit of those family members not in the business to equalize what each member receives. Sometimes, it isn’t meant to equalize but rather to be fair as the business owner sees it. Additionally, if the business will be continued by one or more family members, key person insurance on the owner is important. Apart from the circumstances previously described regarding key persons, the business may have debts whose payment can be accelerated by the lenders if the owner dies. Some lenders will require insurance on the owner’s life to cover the debt.
1. For clarification, most people don’t need life insurance. Their beneficiaries do.2. A 20-year term policy on a female in either the first or second best rating class will cost about $1,000/year.
3. For a more compete discussion on policy selection, see Charles L. Ratner and Lawrence Brody, “Life Insurance Policy Selection and Design,” Trusts & Estates (April 2017).
4. Policies can lapse. Some policies are more complicated than others. Policies need to be explained so that clients understand what they’re buying. The assumptions used need to be explained to the client, and the client has to agree.
5. There must be several congressional staff people who work on coming up with names for legislation that have catchy acronyms.
6. These are the most complicated life insurance policies ever offered and require a great deal of consumer education and understanding.
7. Policies should be structured so that they aren’t considered modified endowment contracts (MECs). If they’re considered MECs, they’ll be taxed like an annuity—gain being taxable and coming out before basis. There can also be a 10% penalty for distributions before age 591/2.