Reasons to Buy Life Insurance
Guest Posting By Aaron Crowe
One of the most common reasons to buy life insurance is to replace income if a spouse dies.
… That’s a great reason and one that makes a lot of sense if your family depends on your income.
But there are other times when life insurance can be a smart thing to have.
For business owners and the wealthy, it can be a way to ease financial burdens other than lost income. It can be used in planning to pass on a business, pay taxes or for estate planning, for example.
Quick Guide to 7 Lesser Known Reasons to Buy Life Insurance
- Pay Estate Tax
- Second to Die Life Insurance
- Irrevocable Life Insurance Trust (ILIT)
- Loan Assets to Create Estates for Grandchildren
- Start a Business
- Cover Real Estate Investments
- Life Insurance to Cover Special Needs Fund
Here are seven lesser known examples of life insurance doing much more than replacing a breadwinner’s income:
Helping to pay estate taxes is one of the many reasons to buy life insurance. As of 2014, individuals may have an estate value up to $5,340,000 without owing federal estate tax upon death. Anything over that exclusion amount is taxed at a 40 percent rate. The exclusion is double for a married couple. Because not everyone’s assets are liquid, the heirs may have a difficult time coming up with the money to pay the tax bill. A life insurance policy can be used to bridge that cash shortage to pay those taxes, says Laura Stees, a CPA in San Diego with a background in estate planning.
For example, someone with taxable estate of $6,000,000 will end up with an estate tax bill of $264,000. If the estate does not have that cash available for the heirs to pay the taxes, Stees says, a life insurance policy in that amount could be used to pay the taxes. A double benefit is that life insurance proceeds aren’t taxed, from an income-tax standpoint.
This is really a simple financial decision.
If you know your estate will owe $264,000, per the example above, would you rather set aside the cash needed to pay Uncle Sam, or pay pennies on the dollar and purchase a life insurance policy to cover that expense?
To make sure that the life insurance coverage is enough, the insured should meet with their financial advisers every three to five years to increase coverage if their estate grows, Stees says. The policy’s value should be projected out with their life expectancy and what their estate could grow to, says Stees.
This type of policy provides a married couples’ heirs (not the surviving spouse) with money that may be needed for a variety of reasons, including to pay estate taxes, says Michael Thornton, a CPA at Brown, Thornton, Pacenta and Co. in Pensacola, Fla. Thornton recommends it to clients who have younger wives who are expected to outlive their husbands, but don’t need the life insurance money.
“A lot of my clients aren’t on their first marriage,” he says. “They’re on their trophy wife. They’re on their second wife.”
The policy is offered at a cheaper rate than policies that insure an single individual, because it only pays out after the second person in the marriage dies. The younger wife, for example, doesn’t need an insurance payout when her husband dies because she already inherits his assets, Thornton says. And there isn’t an estate tax on the surviving spouse when the estate is left to her, he says.
“It’s not life insurance to take care of the family,” Thornton says, adding it allows the estate tax to be covered without buying insurance for both people.
The insurance money upon the second spouse’s death could be useful in paying estate taxes, because the family business or family farm isn’t liquid and cash can’t be pulled out easily, he says, or the estate now has a portfolio of stock that they don’t want to disturb so they can be used to help grandchildren or great-grandchildren.
This is often one of the overlooked reasons to buy life insurance.
As the name implies, this type of policy can’t be changed and is meant to protect an estate, Thornton says. The insurance policy isn’t part of the estate because it isn’t owned by the insure. So estate taxes are reduced. A trustee, usually a bank or trust company, manages the trust and pays the insurance premiums, and distributes the insurance benefit to the trust beneficiaries after the insured person dies.
By having the life insurance policy outside of the estate, the policy isn’t taxed as part of the estate and lowers the tax bill, Thornton says. It’s another way to use life insurance benefits to pay estate taxes and preserve a business, farm, artwork or stock portfolio without selling them off, he says.
These estate tax paying methods are usually used by families with at least $10 million in assets, or $5 million for a single individual, Thornton says.
When you are looking for reasons to buy life insurance be sure to check out a technique called a “generational split dollar”. A wealthy grandparent may create another form of a life insurance trust for the benefit of his or her grandchildren. A grandmother, for example, can loan money to her children to buy life insurance policies that will create estates for her grandchildren, says Joe Strazzeri, a San Diego attorney at Strazzeri Mancini LLP who does estate planning.
Strazzeri has a client who is a widow and in her 80s who would face a large estate tax. She is loaning two of her children $2.5 million each to buy life insurance on their own lives, and is to be purchased through a trust that will be repaid upon her children’s death. Usually the loans would have to be repaid during the widow’s lifetime but the generational split dollar allows the money to be repaid long after her death to her grandchildren, essentially setting up a trust for them.
“She wanted to do it in a way that would help her children feel good about their own estate planning,” Strazzeri says.
The daughters each spent the $2.5 million on life insurance policies. One has a death benefit of $7.8 million and the other a $9.5 million payout, with one building cash value and the other having a higher death benefit.
The cash value from a whole life insurance policy can give a return of 3 to 4 percent, which after 15 years can be a good nest egg to borrow from as seed money to start a business, says Hardy Eubanks, a CPA with Thornton and president of UBX Financial Freedom, which offers financial planning services.
Walt Disney, Ray Kroc and J.C. Penney used such policies to start their businesses, Eubanks says, proving that a low but steady return on a cash-value insurance policy can lead to a fair amount of money to borrow.
“Three to 4 percent beats the heck out of a kick in the teeth, especially when you owe money to someone,” Eubanks says.
Money borrowed from a whole life insurance policy can also be used to pay for college without having a bank loan officer question what the money’s being used for, he says.
“There’s a lot of opportunities to use cash value without somebody telling you how to use it,” Eubanks says.
The money doesn’t have to be repaid. The benefits are reduced by the outstanding loan balance. The loan isn’t taxed as an income tax, except on multi-millionaires who are subject to the estate tax, he says.
For real estate investors, it can take 20 to 30 years before some rental properties generate cash flow, says Stees, who has recommended buying life insurance to cover such cost if an investor dies. The life insurance benefit can pay off a mortgage or at least pay the mortgage bill for six months to give a family a financial cushion for a while, she says.
Life insurance also provides another way to pay estate taxes if the owned properties don’t generate enough cash flow or if the heirs have difficulty selling in a down economy, Stees says. “You might be forced to do a fire sale, and you certainly don’t want to do that,” she says.
Without life insurance, a client of Pablo Palomino, a trust and estate planning attorney in San Diego who is the founder of Legacy, APC, was concerned about caring for her special needs son if something happened to her. A widow in her 70s, she didn’t want to take the risk of selling any of her four properties in a down market to fund a special needs trust, Palomino says.
“The obvious solution was for her to purchase a life insurance policy and name the trust as the beneficiary,” he says. “Not only does this strategy provide liquidity to her estate and protect her current properties from being sold in a distressed sale, but it also greatly enhances the value of her estate in the form of an immediate tax free benefit to her son’s trust.”
Money held in the trust will be protected from lawsuits, creditors and predators, and preserves government benefits to her son such as Social Security income, Palomino says.
With all of these recommendations for buying life insurance, it’s important to remember to review your policy regularly to make sure you have enough coverage as your assets grow. If you’re going to do this much planning for your family, you might as well keep it updated so they’re not caught short.
If you are looking to explore reasons to buy life insurance, give us a call us today at 888-603-2876! We’ll help you find the right policy for you at the best possible prices.
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