Life Insurance in

Estate Planning

 Life Insurance
o A contract with an insurance company that provides
either a lump sum or annuity at death of insured
• Beneficiaries listed by policy
• If no living beneficiaries at death, part of estate
of deceased, and distributed by will or state rules
o Policies can carry riders or features
• Cash Surrender Value (Whole Life)
• Borrowing rights at “reduced” rates
• Ability to increase death benefit over time
 Parties to a Life Insurance Contract
o The Owner of the Policy --- the one who has title of the policy and
can make future decisions about the policy including
• Change beneficiaries of the policy
• Borrow from the policy (if borrowing feature part of policy)
• Pledge the policy against loan
• Change the premium payments (increase or decrease)
• Cancel policy
o The Insured of the Policy – Individual’s death that activates payment
of death benefit
o The Beneficiary of the Policy – the individuals, charities, or
institutions that receive some or all of the death benefit
 Why Buy Life Insurance? Or When is Life Insurance
necessary?
o What asset are you trying to “protect” with proceeds
• Future Income stream for loved ones (liquidity and long term)
• Estate taxes and debt retirement for loved ones (liquidity)
• Educational or medical costs covered for loved ones
• Cover burial, medical, or other expenses of deceased (liquidity)
• Retirement income (couple or surviving spouse)
• Create or sustain family wealth
o Who should own policy? Depends on the assets being protected
 Change in requirements for Life Insurance over the life of an individual
(see Life Insurance Matrix)
o Height of needed insurance, point where not needed and when to start
 Worksheet on Life Insurance Proceeds to Replace
Spouse Income
o Example on Page 451 to 452 – Jack and Jill
• Determine the annual income to replace
• Determine the annuity present value (for a perpetuity)
• Perpetuity is the Life Insurance lump sum payout at death
• Determine annual withdrawals adjusted for inflation
• Forty year income stream
o Spreadsheet for Client – explains the withdrawals and reinvestment
 Does paying off mortgage with death benefit (policy on
outstanding balance of mortgage paid at death) reduce
monthly expenses by size of mortgage? Not really, Why?
 Types of Life Insurance
o Term Life Insurance
• Policy is for specific time period – the term of the contract
• Policy pays a “death benefit” if and only if the insured dies prior to the
end of the term
• Policy is usually paid for with annual, semi-annual, quarterly or monthly
payments to insurance company
• Policy payments stop at death of insured or if policy is cancelled
o From the Insurance Company’s Perspective
• Policy premium is a put option on the insured
• Value of contract is determined by factors (interest, expected life of
insured, interest rates, and payout (strike price of contract))
• Option because strike price paid if and only if death occurs
 Types of Life Insurance -- continued
o Universal Life Insurance
• Two Parts – Term Insurance and Cash Accumulation Account
• Policy Premium is cost of term plus and investment election
• Total premium is paid to cash accumulation account and insurance
company “pays” annual premium from cash accumulation account
• Cash accumulation account is “invested” asset for policy and earns
income (can be set rate or variable)
• Individual can “withdraw” from cash accumulation account
• Policy is cancelled if cash accumulation account is insufficient to pay
annual premium
o Insurance Company provides two simultaneous services
• Risk coverage
• Investment
 Types of Life Insurance -- continued
o Variable Universal Life Insurance
• Two Parts – Term Insurance and Cash Accumulation Account
• Policy Premium is cost of term plus and investment election
• Total premium is paid to cash accumulation account and insurance
company “pays” annual premium from cash accumulation account
• Cash accumulation account is “invested” at the direction of the policy
holder – usually options provided by insurance company
• Individual can “withdraw” from cash accumulation account
• Policy is cancelled if cash accumulation account is insufficient to pay
annual premium
o Insurance Company provides two simultaneous services
• Risk coverage
• Investment
 Types of Life Insurance -- continued
o Whole Life Insurance
• Two Parts – Permanent Insurance and Cash Accumulation Account
• Permanent insurance for life of insured (does not have a preset end or
term)
• Policy Premium is cost of permanent plus and investment account
• Total premium is paid to cash savings account and insurance company
“pays” annual premium from cash accumulation account
• Individual can “withdraw” from cash accumulation account
• Policy is cancelled if cash accumulation account is insufficient to pay
annual premium
o Insurance Company provides two simultaneous services
• Risk coverage with guaranteed payment whenever death occurs
• Investment
 Types of Life Insurance -- continued
o Second-to-Die Insurance
• Two Individuals insured but payment at second death
• Can be Term, Universal, Variable, Whole Life Insurance
• Policy Premium is cost of insurance choice and if elected, investment
• Typically Policy is part of an Irrevocable Life Insurance Trust
• Often used when one spouse is uninsurable (probably will die first)
• Policy is cancelled if premiums not paid
o Insurance Company provides two simultaneous services
• Risk coverage with payment whenever second in death occurs
• Investment – option to add this based on type of policy selected
 Life Insurance and Taxes
o In general, the death benefit proceeds from a life
insurance policy are not taxed
• You can think of the policy premiums as the expense of
the asset and death benefit is return of the principal
o Transfer for Value
• If the life insurance policy is transferred to another
individual, the proceeds can be taxed
• If the transfer is gratuitous – no tax
• If transfer provides benefit to original policy holder –
death benefit minus consideration is taxable
 Exceptions to the Transfer for Value Rule
o Transferred to the insured (Policy holder transfers policy
to the insured individual)
o Transferred to business partner of insured
o Transferred to partnership of insured
o Transferred to corporation where insured is a
shareholder or officer
o Transferred to policy holder that takes the basis of the
original policy holder
 Future cancellation of transfer does not avoid taxes
 Settlement of Life Insurance Proceeds
o Death Benefit Paid at death of insured
• Lump Sum at death (typically as close to death as possible)
• Benefit left with Insurance Company and interest from benefit paid to
beneficiary – income is taxed as ordinary income and benefit paid out
at later date
• Annuity paid to beneficiary – portion of annuity is principal of benefit
and portion is income and taxed as ordinary income (amortization of
the benefit)
o Early Payout – Cash Surrender
• Election to receive benefit prior to death (only for whole life policies)
• Surrender value is percent of death benefit minus administrative costs
of the surrender
 Modified Endowment Contracts
o Contracts set up to look life a variable life insurance contract but…
• Set up to avoid taxes
• Cannot qualify for tax relief if the policy payments are front loaded
• Rule is if policy is essentially paid up before seven years it is a MEC not
a life insurance policy
• Earnings (interest income) is taxable as ordinary income
• Death benefit – when paid – is still free of tax
 Exchanges
o Typically free of tax and basis is original basis plus cost of exchange
 Early pay-off for terminally or chronically ill insured
o Payment to chronically ill for actual out of pocket medical expenses
 Gift Tax Treatment of Life Insurance
o In general, if the beneficiary is not the policy holder, the proceeds at
death of the insured are a gift from the policy holder to the
beneficiary
• Example, Hillary owns a life insurance policy on Bill. At Bill’s death the
policy has Chelsea as the beneficiary and a $2,000,000 benefit is paid
to Chelsea
• Hillary has made a $2,000,000 gift to Chelsea (and may need to pay a gift
tax depending on unused one-time exemption)
• Chelsea receives a tax free income of $2,000,000
o If beneficiary is a charity, payout is to a charitable gift and may be gift tax
free (some special considerations need to be met for gift exclusion)
 Three year look back applies to insurance payouts on policies that cover
the owner and are gifted. Death benefit is part of the estate.
 Irrevocable Life Insurance Trust (ILIT)
o Insurance Policy purchased on an individual and the trust “owns”
the policy not the insured – trustee has vested title of policy
o Since insured is not owner of policy, not part of estate at death
o Trust has beneficiary other than insured (otherwise the death
benefit gets paid to the estate and is part of the estate)
o Trust pays policy premiums – Trust maker (the insured) makes
transfers to the trust for premium payments
o Transfers are considered present gift (not future interest) if there is
a Crummey provision – beneficiaries have 30 days to withdraw the
transfers to the trust for their personal consumption
o With Crummey provision transfer is gift but eligible for annual
exclusion up to the number of beneficiaries in trust
 Example of an Irrevocable Life Insurance Trust (ILIT)
o Joe sets up an ILIT with his wife Jill, and two sons, Beau and Hunter
as the beneficiaries (each to receive 1/3)
o Joe instructs trustee to purchase a $3,000,000 life insurance policy
(whole life) on his life (expected life of Joe, 30 actuarial years)
o Trust has Crummey Provision for the three beneficiaries
o Joe makes annual transfers of $42,000 to pay the premium on the
policy (and applies 3 x $14,000) the annual gift tax exclusion to the
transfer of funds to the trust (hopefully no beneficiary withdraws
contribution as trust would not be able to pay premium)
o At Joe’s death, $3,000,000 passes to his wife and two sons
o The proceeds of the life insurance are not part of Joe’s estate and
payment to beneficiaries is not taxable income
 What are the implications for Financial Planning?
o What options are available to insured?
• Transfers to beneficiaries outside of estate of deceased
• Tax free distribution to beneficiaries
• Gifts to charities
• Payout greater than accrued assets would allow
o How ownership of insurance impact taxes?
• Insured is owner and beneficiary, death benefit part of estate
• Insured is not owner, can pass payout to beneficiary outside of estate
• Can cover partnerships and business agreements at death of partner
o How does payout style impact taxes?
• Lump sum payout tax free to beneficiaries
• Payout over time can have taxable income consequences to beneficiary