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YES, VIRGINIA, THERE IS GOOD LIFE INSURANCE

August 28, 2002

Our last Tax Update described the sad fates of a number of tax planning ideas – ok, we called them schemes – based on life insurance products. While it is important not to get burned by dubious life insurance products, it is also important to use life insurance where it can provide real tax savings and financial advantages.

LIFE INSURANCE DOES HAVE REAL ADVANTAGES under the tax law. The investment buildup in life insurance is not subject to income tax unless the policy is surrendered before death. Investment build-up in a policy may be borrowed tax-free. Policy ownership can usually be structured to keep life insurance proceeds out of a taxable estate. Finally, policy proceeds at death are tax-free. These tax advantages can be very useful in tax and estate planning.

FUNDING ESTATE TAX is one of the most important uses of life insurance. Many estates are illiquid, with most of their value tied up in real estate or interests in closely-held businesses. A life insurance trust can provide the means to pay the estate tax without forcing a fire-sale of the illiquid assets. The trust can use the proceeds of life insurance to pay the estate tax (for example, via a loan to the estate). The trust is “owned” for estate tax purposes by the successor generation, so the life insurance proceeds are not themselves subject to estate tax.

SECOND-TO-DIE policies are often the most cost-effective form of life insurance in a life insurance trust. Most taxable estates only pay estate tax at the death of the surviving spouse. The actuarial odds on two lives are better than on one, so the premiums on second-to-die policies are more affordable than on a given single life.

DEFERRED COMPENSATION PLANS are often funded by life insurance. The cash-value build-up on an insurance policy is often used to fund a deferred compensation arrangement. While the policy is subject to claims of general creditors, it can be a way to assure an executive that the deferred compensation won’t necessarily be deferred forever. Similar results can be achieved by having the employer pay policy premiums on an employee-owned policy – an “executive bonus” plan.

DEATH RISK is the most important reason to secure life insurance. Individuals need to make sure that their families are provided for in the event of an untimely departure. Businesses need to consider “key person” life insurance to cover the costs of a sudden loss of a key player in the business.

BUY-SELL AGREEMENTS of closely-held businesses are often funded with life insurance to provide liquidity for a stock buyout on the death of a large shareholder.

GOOD INSURANCE is acquired for business reasons at a reasonable cost from a major provider in good financial condition through a familiar, knowledgeable and trustworthy broker. If you don’t need permanent coverage or the internal “investment” build-up of life insurance, economical term insurance is good insurance.

BAD INSURANCE is acquired primarily for non-business tax reasons, typically from a company you never heard of, often at an inflated cost, as a result of a solicitation from a broker with whom you have never worked.

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