1. Life Insurance in Estate Planning
Finance 553
Life Insurance in
Estate Planning

2. Life Insurance Life Insurance Beneficiaries listed by policy
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
Policies can carry riders or features
Cash Surrender Value (Whole Life)
Borrowing rights at “reduced” rates
Ability to increase death benefit over time

3. Parties to a Life Insurance Contract
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
The Insured of the Policy – Individual’s death that activates payment of death benefit
The Beneficiary of the Policy – the individuals, charities, or institutions that receive some or all of the death benefit

4. Life Insurance
Why Buy Life Insurance? Or When is Life Insurance necessary?
What asset are you trying to “protect” with proceeds
Future Income stream for loved ones
Debt retirement for loved ones
Educational costs covered for loved ones
Cover burial, medical, or other expenses of deceased
Other support for loved ones
Change in requirements for Life Insurance over the life of an individual (Life Insurance Matrix)
Height of needed insurance and point where not needed
When to start (when to buy first policy)

5. Life Insurance
Worksheet on Life Insurance Proceeds to Replace Spouse Income
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
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?

6. Life Insurance Types of Life Insurance 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
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

7. Life Insurance Types of Life Insurance -- continued
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
Insurance Company provides two simultaneous services
Risk coverage
Investment

8. Life Insurance Types of Life Insurance -- continued
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
Insurance Company provides two simultaneous services
Risk coverage
Investment

9. Life Insurance Types of Life Insurance -- continued
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
Insurance Company provides two simultaneous services
Risk coverage with guaranteed payment whenever death occurs
Investment

10. Life Insurance Types of Life Insurance -- continued
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
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

11. Life Insurance Life Insurance and Taxes Transfer for Value
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
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

12. Life Insurance Exceptions to the Transfer for Value Rule
Transferred to the insured (Policy holder transfers policy to the insured individual)
Transferred to business partner of insured
Transferred to partnership of insured
Transferred to corporation where insured is a shareholder or officer
Transferred to policy holder that takes the basis of the original policy holder
Future cancellation of transfer does not avoid taxes

13. Life Insurance Settlement of Life Insurance Proceeds
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)
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

14. Life Insurance Modified Endowment Contracts Exchanges
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
Typically free of tax and basis is original basis plus cost of exchange
Early pay-off for terminally or chronically ill insured
Payment to chronically ill for actual out of pocket medical expenses

15. Life Insurance Gift Tax Treatment of Life Insurance
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
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

16. Life Insurance Irrevocable Life Insurance Trust (ILIT)
Insurance Policy purchased on an individual and the trust “owns” the policy not the insured – trustee has vested title of policy
Since insured is not owner of policy, not part of estate at death
Trust has beneficiary other than insured (otherwise the death benefit gets paid to the estate and is part of the estate)
Trust pays policy premiums – Trust maker (the insured) makes transfers to the trust for premium payments
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
With Crummey provision transfer is gift but eligible for annual exclusion up to the number of beneficiaries in trust

17. Life Insurance Example of an Irrevocable Life Insurance Trust (ILIT)
Joe sets up an ILIT with his wife Jill, and two sons, Beau and Hunter as the beneficiaries (each to receive 1/3)
Joe instructs trustee to purchase a $3,000,000 life insurance policy (whole life) on his life (expected life of Joe, 30 actuarial years)
Trust has Crummey Provision for the three beneficiaries
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)
At Joe’s death, $3,000,000 passes to his wife and two sons
The proceeds of the life insurance are not part of Joe’s estate and payment to beneficiaries is not taxable income

18. Life Insurance What are the implications for Financial Planning?
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
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
How does payout style impact taxes?
Lump sum payout tax free to beneficiaries
Payout over time can have taxable income consequences to beneficiary