Providing financial support for our loved ones when we are no longer here is a difficult subject to discuss and requires us to not only look at how much support is necessary, but also how we want to provide this support. One solution is to purchase a life insurance policy that provides our heirs with assets upon our death.
The first step in purchasing life insurance is to determine how much life insurance we need. We discussed some of the important factors in arriving at this dollar amount in our previous article Considerations for a Life Insurance Needs Analysis. The next step after determining how much life insurance we need is to purchase a policy with features consistent with our goals.
There are four main types of life insurance policies to consider during your life insurance analysis; however, there are also several options within each policy that can customize the policy to your needs. These options include who is covered by the policy, how long premiums must be paid and what additional benefits may be available within the policy. Since the need for these additional features will vary based on the individual, we are going to look at each type of policy at a high-level.
Term policies offer coverage for a specified period, usually 10, 20 or 30 years, though additional coverage terms are available. As with any life insurance policy, term insurance guarantees a payout of the death benefit if you die within the specified term. If you outlive the term of the policy, the policy expires without ever paying out.
Term policies typically have lower premiums than permanent policies due to coverage only lasting for a specified period. While there are a handful of reasons why a term policy may be right for you, the most popular reason is to provide the liquidity to pay off a large debt or expense in the event of your death.
Whole life policies are a form of permanent life insurance, meaning coverage will last the entirety of your life, as long as premium requirements are met. Whole life policies offer a specified death benefit as well as a cash value. When you pay your premiums on a whole life policy, a portion of the premium goes towards the cash value and will grow tax-deferred at a guaranteed rate. The cash value can serve as an addition to the death benefit or can be accessed during the life of the insured for other purposes.
Whole life policies are typically used to provide liquidity for your beneficiaries, regardless of the timing of your death. They also provide another opportunity to build tax-deferred wealth to supplement retirement income and/or leave a legacy for your heirs.
Universal life policies are like whole life policies in that they are a form of permanent insurance and carry a cash value. These policies are used for similar reasons, but a universal life policy offers more flexibility on when premiums are paid and how the cash value accumulates.
While whole life policies have a fixed premium, universal life policy premiums may increase over time to account for the aging and insurability of the insured. While whole life policies offer a guaranteed interest rate on the cash value, the interest rate on universal life policies are based on current market conditions – usually subject to a guaranteed minimum. Universal life policies can also use the cash value to pay premiums, reducing the risk of the policy lapsing due to missed premiums.
Variable Universal Life
Variable universal life is another form of permanent life insurance that has similar uses to whole and universal life policies. Like universal life insurance, the premiums in the variable universal life policy are flexible, may increase over time and may be paid using the cash value of the policy.
The biggest differentiator when it comes to variable universal life policies is that the cash value can be invested in a variety of subaccounts. These subaccounts function in a similar manner to mutual funds, allowing you to invest in different areas of the market. The flexibility offered by the investment options within this policy provides for more growth potential in the cash value, however this growth potential does come with the additional risk associated with investing. These policies are typically the most expensive due to the additional fees associated with subaccounts.
Irrevocable Life Insurance Trusts
An irrevocable life insurance trust (ILIT) is a form of irrevocable trust that not only works to remove the policy from the insured’s estate, but also to manage the distribution of policy proceeds upon the insured’s death.
When you are both the owner and insured on a life insurance policy, the death benefit and cash value will be included in your estate. To remove the policy from your estate, you can transfer it to an ILIT, making the trust the owner and beneficiary of the policy. If you don’t currently own a policy but would like to take advantage of the benefits of an ILIT, you can establish the ILIT and then have the ILIT purchase the policy on your life. The ILIT can work to reduce your estate tax liability by not only removing the policy from the estate but can also provide a way for you to gradually reduce your estate over time. This can be done by gifting the cash from your estate to your ILIT utilizing annual exclusion gifting and Crummey powers of withdraw. Once the cash is gifted to the ILIT, the ILIT can use it to pay the premiums on the policy to keep it in force.
Aside from reducing the size of your estate, ILITs can allow you to specify how the death benefit should be paid out and under what circumstances the beneficiaries may access their share of the proceeds. Not only does this feature allow the trustee to teach your beneficiaries to use this inheritance responsibly but can potentially allow you to build a legacy for further generations.
Life insurance and irrevocable life insurance trusts are great tools that can serve many purposes in your financial plan. It is important to understand the intricacies of each option before deciding which is best for you. A Financial Advisor can help you understand these details and determine which strategies you can benefit from.
For more information on unique ways life insurance may be used, listen to our podcast episode here.
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