Life Insurance as an Estate Planning Tool: A Primer
Excerpted from Asset Protection Strategies by Alan R. Eber, Dustin Nichols and Mark Ziebold
For attorneys who have not obtained their life insurance licenses, the world of life insurance can often be an intimidating arena because life insurance agents can seemingly make the numbers do whatever’s necessary to make a sale. Attorneys who practice in the areas of asset protection, estate planning, or both need to be well versed in the various types of policies to ensure that their clients are properly advised and not taken advantage by agents eager for a big commission. If the client purchases the wrong type of policy, the client may waste years of premiums. By then, the client may be unable to purchase the type of coverage needed due to declining health.
When it comes to estate planning, life insurance may play a major role. Below are examples of life insurance, along with discussions about the advantages and disadvantages of such contracts.
Five Categories of Life Insurance
Term Insurance
This type of insurance is the most common type sold today. It provides no cash value buildup and provides a certain death benefit if the insured passes away within the term of the insurance. Typical terms for this type of insurance are 10-year, 20-year, and, with some carriers, 30-year terms. During the term of the policy, the premiums are fixed and then dramatically increase after the end of the stated term.
Some uncommon types of term policies repay a portion of the premiums in the form of a policy dividend and some specific types of term policies repay all of the premiums paid during the term (called a return of premium rider) if the policy remains in effect for the required period of time.
Clients should also be aware of the cost of added provisions in these contracts, called riders, that can allow conversion of term insurance contracts to permanent insurance products. The costs associated with these riders vary from carrier to carrier and should be discussed with the life insurance agent before finalizing the insurance purchase.
Whole Life Insurance
This, along with the types of policies that follow, is a permanent life insurance product. This means that once the insured qualifies for life insurance and the insurance carrier issues the contract, it cannot be revoked by the carrier if the insured becomes uninsurable due to health conditions.
Whole life insurance combines a death benefit with a savings component. The savings component is made up of investments at the carrier level that provide growth of the cash value of the policy over time. Some carriers have dividend paying whole life contracts that combine the elements of growth in the underlying investments and a dividend to the cash value at certain times in the company’s discretion. Whole life contracts often have guaranteed cash values, returns on the cash values, and death benefits depending on the carriers and the contract.
Universal Life Insurance
Similar to whole life contracts, this is a type of permanent insurance. This type of insurance separates the insurance costs from the investments. The owner of a policy can add contributions to the investment portion at any time and access these funds by withdrawals or loans from the policy. The death benefit on these types of contracts can be a level death benefit (often called an Option A contract) or an increasing death benefit (often called an Option B contract). These types of policies often have returns that are in the area of a bond fund unless a policy has other investments that are specifically identified in the contract.
Variable Life Insurance
These types of contracts are structured like other permanent policies, but the investment component of the policy is directed to one of many types of invesment accounts that operate similar to mutual funds inside the life insurance policy. These policies have the greatest upside as the actual investments inside the policy can provide large returns when the market has positive gains. However, because the cash is invested in these types of accounts, the value can drop if the market has a negative return in a given year. In general bull markets, these are the types of policies to have because you see the benefit of unlimited upside in the growth of the cash value due to the market upswings. They are also the types of policies that you would want to avoid in a down market as the policy normally has no downside protection (so if the market dips by 50% in a given year the cash value will also lose approximately 50%, depending on the chosen investments within the contract).
Indexed Universal Life Insurance
This insurance is a type of permanent universal life policy where the carrier invests in options against an index such as the S&P, Dow Jones, etc. Because the internal cash value is not invested in the market, these types of contracts are not subject to market downturns. However, the growth of the cash value is capped in any given year so that part of the upside growth is given up in exchange for the downside protection. The upside growth is generally capped by the contract in between zero for the year and 12 to 18 percent depending on the contract and the issuing carrier. These are often the best contracts for situations such as premium financing as they are not considered to be a security like the variable life contracts for collateral purposes and guaranty at least a zero rate of return on the cash value in any given index period (year, month, etc.), which is very popular with lending institutions.
Advantages of Term Insurance Contracts
•Lowest cost insurance as the owner is paying for the death benefit for a term of years and for none of the other benefits that are outlined above with permanent life insurance policies.
•May not need a full physical depending on the amount of death benefit sought.
•Usually easy to purchase and determine how much death benefit is needed for a given period of time in a client’s life. This type of contract is often used for income replacement in the event of a working spouse’s death, or to pay college expenses for children or any other expenses that could not be provided for if the working spouse prematurely died.
Disadvantages of Term Insurance Contracts
•No build up of cash value inside the contract, therefore losing one of the main benefits of using insurance under the Internal Revenue Code.
•Unless a conversion rider is purchased, the client may be uninsurable at the end of the term due to health factors.
•Due to the wide variety of companies that sell term insurance, the financial strength and solvency of the companies are often not known or investigated.
Advantages of Permanent Insurance Contracts
•In addition to the death benefit, some policies have a cash value component. The growth of the internal cash value is income tax free based on the fact that it occurs within an insurance policy.
•Owners of the policy can access the cash value income tax free if certain rules are followed under IRC §72
•These policies have many applications from supplemental retirement income, increasing death benefits for high net worth tax planning, etc.
•Some types of contracts have minimum guarantees to earn at least a certain percentage on the cash value from year to year.
Disadvantages of Permanent Insurance Contracts
•Growth of the cash value above the guaranteed growth by contract usually depends on the underlying investments, which can be positive or negative in a given year.
•Growth may not be enough for the chosen application (for example, a whole life contract may not earn enough internally to capitalize the interest in a premium financing situation).
•A variable contract can lose value in a market downturn.
•An equity indexed contract may return zero in a given year based on market downturns, and the internal cash value can go down due to expenses and insurance charges.
About the Authors
Dustin Nichols, J.D. is a Distinguished Faculty Member for Lorman Education Services, a national provider of continuing legal education seminars and often speaks on the topic of Integrated Estate and Asset Protection Planning. He conducts private seminars for large CPA firms and financial professionals on estate strategies and advanced wealth preservation techniques.
Mr. Nichols is a Member of the California State Bar, is certified before the U.S. Tax Court, and is licensed to practice before the United States District Courts in the Eastern and Central Districts of California. He can be reached at 949-240-1101 or [email protected].
Mark A. Ziebold, J.D., LL.M is the owner of the Ziebold Law Group. He concentrates his practice in estate planning, trust administration, charitable organizations, asset protection, business formation, athlete representation, family office services, and estate, gift, income, and generation skipping tax planning. He has worked with private clients and institutions to implement premium financed life insurance strategies.
Mr. Ziebold has obtained the Certified Asset Protection Planner and Certified Wealth Preservation Planner designations from the Wealth Preservation Institute and is a member of the California, Nevada, Arizona, and Texas State Bars. Mr. Ziebold is a certified by the State Bar of California as a specialist in Taxation and in Estate Planning, Trust, and Probate Law. He can be reached at 949-788-1819 or [email protected].