Life Insurance Basics 

​

Life insurance is a contract between the insurer and the insured which provides for the payment of premiums in exchange for a death benefit.

​

Why Purchase Insurance

Life insurance should be purchased to meet a stated goal in the event of an insured's death.  Common goals include replacing a wage earner's income, providing funds to buyout a partner/shareholder's interest in a business, protecting a business against the death of a key person, and replacing wealth lost by the payment of estate taxes.  Before purchasing insurance, you should identify and quantify your goal.  This will help you determine what type and amount of insurance is right for you.

​

Types of Insurance

There are many types of life insurance, but they boil down into two basic groups:  temporary (term) insurance and permanent insurance. 

​

Term insurance provides a death benefit if death occurs in a fixed period of time, usually one year.  The policy has no "cash" value -- once it terminates, coverage ends and the insured receives no payment.  A term insurance policy can be renewable or nonrenewable, and can (but is not required to) provide a guaranteed premium for a certain number of years.  For younger persons, term insurance is inexpensive since the risk of dying is generally small.  As the insured ages, the cost of term insurance increases -- dramatically as the insured nears the end of his or her projected life expectancy.  Term insurance is usually used where the insured has a short-term need for a death benefit.

​

In contrast, permanent insurance provides a death benefit which will not lapse as long as the insured makes premium payments in accordance with the insurance policy.  In other words, a permanent life insurance is non-cancellable, and does not provide for increasing premiums as the insured ages.  Permanent insurance builds up a cash value during the life of the insurance policy. As a result, permanent insurance is initially more costly than term insurance (for the same death benefit) because part of the premium paid is used to accumulate cash value.   However, because of the buildup of cash value and the level premium, in the long run permanent insurance is actually less costly than term insurance.

​

Permanent insurance comes in several flavors:  whole life, universal life and variable life.  Whole life insurance is the traditional type of permanent insurance, where the premium and death benefit is fixed during the life of the insurance contract.  The buildup of cash value is dependent on the performance of the insurance company, much in the same way the value of stock is dependent on the performance of the underlying company.  Universal life insurance is more flexible -- the insured is allowed to vary the amount of premium and death benefit; the buildup of cash value remains dependent on the performance of the insurance company.  Variable life is like universal life, except the insured is permitted to choose how the policy's cash value will be invested.  Insureds can usually pick from an assortment of funds, which include funds that participate in the stock markets.  In a variable life policy, the investment risk is shifted to the insured.

​

What is a Life Insurance Trust?

​

A life insurance trust is an irrevocable trust which is specially designed to hold, manage, and administer one or more life insurance policies.  Properly drafted, a life insurance trust allows the trust's grantor to fund the payment of insurance premiums during life, and to direct the distribution of the proceeds from the policies upon death, while avoiding estate and gift taxation on these transfers.

Here are the key elements of a properly drafted life insurance trust:

​

(1)  The grantor cannot be the trustee of the trust.  If the grantor is named as trustee, or has the possibility of becoming trustee, then he or she will deemed to be the owner of the life insurance policy for estate tax purposes, and the proceeds of the policy will be included in the grantor's estate at death.

​

(2)  The trust must be irrevocable.  If the grantor reserves the power to amend, alter or revoke the trust, then upon death the proceeds of the life insurance held by the trust will be included in the grantor's estate.

​

(3)  The grantor cannot control the life insurance policy.  The grantor cannot reserve any control over the life insurance policy.  Any such control, known as an "incident of ownership," will cause inclusion of the proceeds in the grantor's estate.

​

(4)  The beneficiaries should be given a limited right to withdraw.  As noted in the discussion on Lifetime Gifts, if you limit the use, possession or enjoyment of a gift to a future date, then the gift will not be a gift of a present interest, and therefore will not qualify for the annual gift tax exclusion.  One way to circumvent this problem is through the use of a trust which gives the donee the a limited power to withdraw the gift from the trust.  This power is known as a Crummey power -- after the name of a famous case which upheld it use as an estate planning tool.

​

(5)  The trust should own the life insurance policy.  Since the grantor cannot control the life insurance policy, the trust should be the policy's owner and designated beneficiary.  If possible, pre-existing life insurance policies should not be used to fund the trust; rather, life insurance should be purchased by the trustee after the trust is established.  Under some rather arcane rules, if pre-existing life insurance is used, and the grantor dies within three years of transferring the policy to the trust, then the proceeds of the policy are included in the grantor's estate.

​

Reducing Estate and Gift Taxes

​

A life insurance trust can help you avoid estate and gift taxation in several ways. 

 

First, you can make annual gifts to the trust in an amount sufficient to pay the premiums on insurance owned by the trust.  If these gifts are under the annual exclusion amount, and a Crummey power is included in the trust, no gift tax will be due (and you will not consume your unified credit -- see Exclusions at the Lifetime Gifts webpage).  Moreover, by making these gifts to the trust, you will reduce your overall estate, thereby ultimately reducing estate taxes.

​

Second, by using a properly drafted life insurance trust, the trust beneficiaries will pay no estate tax on the proceeds, nor will the proceeds count against your unified credit.  The proceeds pass free of any tax:  estate, gift or income.  Better yet, you can attach strings to the proceeds, since you can dictate how and when the proceeds will be distributed.  This is especially helpful when planning for minor children.

​

Second-to-Die Life Insurance

​

Second-to-die (or survivorship) life insurance is exactly what its name indicates -- it is a life insurance policy that pays a death benefit only after the death of two named insureds.  Since your beneficiaries would have to wait longer to receive the proceeds, why buy a second-to-die policy?  The answer is price:  a second-to-die policy is usually much cheaper than a single life policy since the insurance company will not have to payoff until the death of the second insured.  For married couples, this is often a great choice since the need for life insurance is greatest on the death of the last spouse to die (when estate taxes are imposed).  Because of this price feature, second-to-die policies are often used to fund life insurance trusts for the purpose of providing the funds needed to pay or offset estate taxes.

​

Other Purposes of Life Insurance

​

As mentioned briefly above, life insurance can play many roles beyond estate tax planning.  Probably the most common purpose of life insurance is to replace the loss of a wage earner.  Many families now depend on two incomes -- the loss of either could be catastrophic.  Life insurance can protect a family from the loss of one (or both) of the wage earners.  Often, the biggest issue in a family setting is cost, and many people purchase term insurance because it is initially the least expensive.  In the long run, this decision could actually cost the family more than purchasing permanent insurance, since the cost of term insurance rises dramatically as the insured gets older.  A very rough rule of thumb:  if you foresee a need for insurance which exceeds ten years, you should consider purchasing permanent insurance.

​

For closely held businesses, life insurance often provides the funds to purchase a deceased shareholder or partner's interest in the business.  If the business relies heavily on the expertise of an individual, life insurance can protect the business from financial difficulties in the event of that person's death.  In a business setting, the shareholders should explore the use of split-dollar life insurance, which can provide a more cost-effective way of providing the funds for a buyout of a deceased shareholder's interest in the business.

​

If you have any questions regarding life insurance or any aspect of the estate planning process, please  contact Richard W. Kozlowski, Esq. at (802) 343-7419 or by e-mail.