Part 1: Estate Planning Guide

Life Insurance: ways to use life insurance in your estate

WHY HAVE LIFE INSURANCE?

Although some people view life insurance as merely a "bet" on when you will die, it has far more important purposes. Life insurance can provide for a variety of financial needs:

• Protection: Life insurance can protect your family and other dependents by replacing your salary if you die.
• Liquidity for Taxes: Life insurance can help make sure that your estate has enough cash to pay estate taxes and other estate expenses.
• Investment Tool: Life insurance can also be used as an investment tool that allows you to defer payment of the taxes owed on your gains.

TYPES OF INSURANCE

The insurance industry has developed many types of insurance products. Some of the more common types of insurance include:

• Term Life Insurance: Usually used only for a short period of time, it consists of only "pure" insurance on your life.
• Whole Life Insurance: Usually permanent, it includes both "pure" insurance on your life and an "investment" component.
• Variable Life Insurance: The amounts of cash value and death benefits are variable, depending on the success of the investments made.
• Universal Variable Life Insurance: Combines features of "variable" and "universal" and allows some flexibility in choosing investments.

Term Life Insurance

Term life insurance includes only "pure" insurance on your life and only for a specified term, usually a period of one to five years. If you outlive the stated term, neither you nor your beneficiaries collect any benefits. If you don’t outlive the stated term, your beneficiaries collect the face value death benefits.

Term life insurance is cheaper to buy than permanent insurance when you are younger, but the rates increase as you age. Term insurance is usually easier to acquire than permanent insurance at any age. Term life insurance is only temporary life insurance. Depending on the individual policy, however, you may be able to renew the policy or convert it to another type that is more permanent.

Whole Life Insurance

Whole life insurance offers pure insurance on your life and provides you with an investment vehicle to accumulate cash value. The amounts that you pay for premiums includes the cost of the pure insurance and the amounts that are invested by the insurance company.

The insurance contract will guarantee a minimum rate of return on the investments, usually between 4 and 6 percent. The cash value may grow at a higher rate than the guaranteed rate, depending on the financial results of the insurance company’s general asset account. No income tax is imposed on the income earned by the investments unless or until the policy is canceled. You are able to take out loans against the cash value and the interest you pay on the loans goes back into your account, less a small service charge. If you do cancel the policy, the cash value is paid out to you less a service charge.

Variable Life Insurance

Variable life insurance is similar to whole life insurance, except the cash value and/or the death benefits are not fixed. They vary depending on the results of the investments made from the owner’s separate account. The owner of the policy chooses how the money is invested.

The insurance company will offer different types of investment accounts to choose from such as stock funds, bond funds, or money market funds. The individual investment accounts are managed by either the insurance company itself, or by an outside investment firm. The goal of variable life insurance is for the death benefits to keep up with the rate of inflation. Care should be taken when purchasing a variable life insurance policy. If the policy lapses due to poor investment performance or unpaid outstanding loans, unfavorable tax consequences may result.

Universal Life Insurance

Universal insurance is permanent life insurance that includes both pure insurance and investment components, similar to whole life. However, universal life insurance allows the owner to adjust either the amount of premiums to be paid or the amount of the death benefits to be paid at death. The rate of return on the investment component is based on the results of the company’s general asset account. The owner is not allowed to dictate what type of investments are made.

Because universal life insurance is intended to be a policy that you keep in effect your entire life, the premiums that you pay can be adjusted so that they are equal over your lifetime, you pay them only for a set number of years, or they are more in the beginning years and then lower in later years, for example after you retire.

Universal Variable Life Insurance

Universal variable life insurance combines the features of universal insurance and variable insurance. The owner is able to choose the types of investments made by the cash value account and the account grows according to the returns on those investments. The owner can also adjust the amount of the premiums or death benefits of the policy. This type of policy offers the owner the most flexibility in meeting his/her insurance needs.

CHOOSING LIFE INSURANCE

The main objective in buying life insurance is to provide adequate resources for your dependents at the time of your death. Other objectives, such as investing, borrowing opportunities, and other non-insurance objectives, should be considered secondary.

• Term or Permanent Insurance: Choosing between term or permanent insurance is the first decision.
• Type of Permanent Insurance: Whole, variable, universal, or universal-variable.

Term vs. Permanent Insurance

A fundamental question that should be asked before choosing between the term and permanent insurance is “which can you afford?”. The rates for term insurance are usually much lower at younger ages, but can increase dramatically after you reach age 50 years. The rates for permanent insurance are usually higher than term rates during the initial years. However, permanent rates offer the advantage of remaining level because the rates are averaged over your expected lifetime. Buy the policy that you can afford.

You also should look at the non-insurance benefits of a permanent policy that build up cash value as opposed to a term policy without a cash value. With a "permanent" policy, the income earned is tax-deferred and you can borrow against the fund without any tax implications.

Because permanent insurance is meant to insure you for your entire life, once you become insured under a permanent policy, you don’t need to worry about not being insurable at a later time as long as the policy premiums are kept up to date. The permanent nature of a permanent policy is probably one of its biggest advantages.

Deciding Between Different Types of Permanent Insurance

If you decide that permanent insurance is best for you, you will need to decide what type of permanent insurance: whole, variable, universal, or universal-variable. Look at the trade-offs between risk and return, the flexibility allowed in the investment portion of the policy, and the flexibility in the premium and death benefit amounts. Below is a table comparing these factors for the different permanent policies.

LIFE INSURANCE TRUSTS

In some estate plans it is desirable or necessary to obtain more life insurance. A life insurance trust offers a solution to the increased estate taxes that can result from owning more life insurance.

• Federal estate tax burden: How a life insurance trust can avoid additional federal estate taxes.
• Setting up life insurance trusts: A life insurance trust is subject to certain requirements.
• Distributing assets: Use of the trust assets after your death and the collection of life insurance proceeds.

Federal Estate Tax Burden

The Problem Illustrated

Stan is single and has a small business worth $1,100,000, a home worth $250,000, a car worth $30,000, and $20,000 in cash. If Stan dies in the year 2002, federal estate taxes on this estate of $1,400,000 would amount to approximately $167,000. Stan decides to buy a $200,000 life insurance policy to provide the necessary liquidity. However, it's not that easy.

• The life insurance increases the value of his estate from $1,400,000 to $1,650,000, which in turn, increases the federal estate tax to approximately $277,000. The $200,000 policy won’t be enough.
• Not only does Stan have to have additional life insurance to solve his initial liquidity problem of $167,000, he also has to buy even more life insurance to cover the additional tax cost associated with an increase in his estate that is caused by the additional life insurance.
• In this example, Stan would have to buy approximately $300,000 to $350,000 in life insurance to solve his liquidity problem.

The Life Insurance Trust Solution

A life insurance trust offers a solution to the spiraling estate taxes that result from increasing your life insurance. Instead of having you own additional life insurance directly, a separate life insurance trust is created to own the additional life insurance. Because the trust owns the policy, not you, the life insurance is not included in your estate.

In the above example, Stan would create a life insurance trust to own the additional life insurance of $200,000. Stan's estate would remain at $1,400,000. At Stan's death, the life insurance proceeds would be paid to the trust. The trust would then make the proceeds available to the estate to help pay the federal estate taxes by making a loan to the estate or by buying a portion of Stan's business from the estate.

Setting Up Life Insurance Trusts

A life insurance trust has the following features. Some of these features are undesirable, but are required in order to gain the estate tax advantage of not including the life insurance in your estate.

• Irrevocable: A life insurance trust is irrevocable, that is, after it has been established, none of its terms can be changed.
• Trustee: As with all trusts, a trustee is required for a life insurance trust. The trustee can be an individual or a bank. However, the trustee cannot be you, and in many
• Obtaining Life Insurance: An application for new life insurance should be made by the trust, not by you as an individual. It is possible to transfer an existing life insurance policy into a trust, but if you do, then the life insurance will still be included in your estate unless you live for at least three more years after the life insurance is transferred
• Ownership/Beneficiary: The trust will be both the owner and the beneficiary of the life insurance. This means that at your death, the life insurance proceeds will be paid into the trust, and not directly to your estate or other beneficiaries.
• Paying the Premiums: The trust will need to make the insurance premium payments to the life insurance company. The trust will not likely have any funds to make the premium payments, and so you will need to transfer funds into the trust from time to time to make the premium payments. You should not make the insurance premium payments directly yourself.
• Collecting the Proceeds: At the time of your death, the life insurance proceeds will be paid into the trust. In many cases, the estate will need the life insurance proceeds to pay estate taxes. The life insurance proceeds can be made available to the estate by loaning the proceeds to the estate or by having the trust buy assets from the estate.

Distributing Assets

Trust Beneficiaries

The trust will need beneficiaries to receive the assets from the trust at a future time. You choose the beneficiaries when you set up the trust. However, the trust is irrevocable and so you cannot change the trust beneficiaries at a later time. This is unlike a will or living trust that you can change at a later time in response to changing wishes regarding beneficiaries. Often the beneficiaries of a life insurance trust are the same beneficiaries as under your will or living trust. If you decide to include your grandchildren as beneficiaries, you will need to take into consideration the effect of the generation skipping tax. This complex tax generally applies to transfers in excess of $1,000,000 to your grandchildren or other persons more than one generation removed from your generation.

Distributions

Generally, no distributions are made from the trust until after your death and the collection of the life insurance proceeds. You can then provide for immediate distribution or you can provide for periodic distributions over a period of years. Keep in mind that if the trust has loaned funds to your estate or purchased assets from your estate, the trust may be distributing the loans or the purchased assets, instead of the cash from the life insurance.

Withdrawal Rights

Your contributions to the trust to make the life insurance premiums are considered to be gifts to the beneficiaries of the trust. Generally, you will want to limit these transfers to a total annual amount of less than $10,000 per beneficiary so that your contributions will qualify for the annual exclusion. The annual exclusion will only be available if you give your beneficiaries the right to withdraw the contributions for at least a 30 day period after you make the contributions. Of course, you are expecting that your beneficiaries will not make the withdrawals. However, if they do make the withdrawals, the funds will not be available to make the insurance premiums. If you don’t give the beneficiaries the right of withdrawal, your contributions will not qualify for the annual exclusion. This means that your transfers into the trust will use up part of your "federal exclusion," an undesirable result.