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Life Insurance: Do You Need It?

October 15, 2015

Life insurance can serve many purposes, and it has both pros and cons for high net worth individuals.

There’s no one-size-fits-all answer to this question. Life insurance can serve many purposes, and it has both pros and cons for high net worth individuals. In certain situations, life insurance can provide significant benefits. But if your net worth is large enough, life insurance is simply another asset allocation, requiring careful assessment and planning.

Liquidity Needs

One situation when life insurance typically can be beneficial is if an estate includes a large, illiquid asset, such as a business or an expansive vacation property. If there isn’t enough liquidity to pay estate taxes, the estate could be forced to sell the asset.

This might mean having to accept a lower-than-desired price in order to be able to pay the estate tax bill on time. Or perhaps it’s an asset the family doesn’t want to part with. Life insurance can provide the liquidity needed to pay the estate tax bill without having to sell the asset.

Even if estate taxes aren’t a concern, the liquidity life insurance offers can be helpful if a family business makes up most of the owner’s estate and some but not all of the owner’s children are active in the business. In such situations owners often have concerns about transferring ownership interests to inactive children, yet they don’t want to disinherit them.

Life insurance can remedy this problem: The inactive children can be named as life insurance beneficiaries while the active children inherit the ownership interests.

Moving Through Life Stages

Life insurance can also be valuable during the wealth accumulation stage of life, when your earning power might still be your biggest asset. You may have young children, a nonworking spouse and a mortgage, and you want to ensure your family can continue to maintain their lifestyle should you die unexpectedly. Plus there are college expenses to think about. Life insurance can replace your income, allowing your family to pay expenses and accumulate more wealth for the future.

But eventually children graduate from college and support themselves and the mortgage is paid off. Your investment earnings may be well exceeding your annual compensation or you may have retired. At this point, the cons of maintaining the life insurance policy you purchased many years ago might be starting to outweigh the pros.

Reevaluating Your Policy

The longer you have a life insurance policy, the lower the return on the investment because you’re continuing to pay premiums yet the death payout remains the same. If you exceed your actuarial life expectancy, then the return is even worse.

Funding the premiums may also become more burdensome, at least from a tax perspective. To keep the policy out of your taxable estate, you likely hold it in an irrevocable life insurance trust (ILIT). The tradeoff is that you can’t have any “incidents of ownership” over the policy (for example, you can’t tap the cash value or change the policy beneficiary) and any transfers you make to the trust to pay premiums will be considered taxable gifts.

With proper structuring of the ILIT, you can apply your $14,000 annual gift tax exclusion (multiplied by the number of ILIT beneficiaries) to the transfers. But the annual life insurance premium may far exceed the exclusion, quickly eating into your $5.43 million lifetime gift tax exemption — and reducing the amount of your estate that can be transferred tax-free at your death.

If the trust is set up as a generation-skipping trust (GST) that provides for children and grandchildren, your exemption will be eaten up even faster. Why? Because the premiums won’t qualify for the annual exclusion for GST tax purposes.

A split-dollar arrangement with another family entity can mitigate premium funding issues, but it has downsides as well. For example, your estate will have to pay back borrowed funds plus interest to the related entity when the policy proceeds are paid out at your death, further compounding the problem of a lower rate of return.

So if your estate is liquid and you’re beyond the wealth-accumulation stage of life, it’s important to run the numbers to see if having life insurance still makes sense from an investment allocation perspective. While the ability of an ILIT to keep a substantial amount of assets out of your taxable estate is attractive, it’s important to remember that there are other estate planning vehicles that will do the same but potentially achieve better results overall.

Achieving Your Goals

As you can see, there are many factors to consider when determining whether you need life insurance coverage — or still need coverage. We can help you address these questions and identify other estate/gift planning vehicles and alternatives if appropriate.

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