It’s not the life insurance product but the process of obtaining it isn’t fun.
You put the life insurance agent/broker in the same category as a stereotypical car salesman. He’s got greasy hair, you’re his newest best friend in the world, and he wants to know, What do I need to do to get you into a policy today? You think he’s out solely to earn a commission. You have nothing against anyone making a living, but you just don’t trust him.
You’ll end up purchasing a product – an intangible product, yet – that you know you don’t fully understand. Clearly, this doesn’t sit well. You’re afraid somebody’s pulling a fast one on you. Did I do the right thing? Am I overpaying? What do other companies offer?
You have a thousand other things to spend your money on that are a whole lot more fun. Eating out. Vacations. Heat tickets. Even saving money and paying bills seems like a better use of your discretionary funds.
You really don’t want to face up to the fact that you’re going to die, and that you don’t know when.
Have I hit any raw nerves? There’s probably a bit of truth in each of these and for each of us.
A life insurance policy is an aleatory contract.
Aleatory contracts are historically related to gambling and appeared in Roman law as contracts related to chance events. In the insurance example, this is because the payouts to the insured are unbalanced. Until the insurance policy results in a payout, the insured pays premiums without receiving anything in return besides coverage. When the payouts do occur, they can far outweigh the sum of premiums paid to the insurer.
This is the crux of the matter: since we’re all going to die, there is a 100% chance the death benefit will be paid out from an in-force life insurance policy. There is nothing else out there – no other financial product – that can benefit so many people for so few dollars.
You’re 35, mortgaged up to your eyeballs, with two children. Retirement accounts at this point are pretty small. If you got in a car crash today your wife would have to go back to work and move your children to smaller quarters. You need a lot of coverage.
Fast forward: You’re 65. You have a successful professional career behind you. Finally, you have fat retirement accounts, and significant other assets: investment accounts, real estate, and other business interests. You’re no longer working to earn a living, so you’re set. No particular life insurance need, unless you want to make substantial charitable contributions or fund future estate taxes.
Which policies are most useful and where?
Here I’ll confess my prejudices. I’m not a big fan of whole life insurance for the average family, because it’s just too expensive. Consequently, I like to see family layer insurance. Say your children are 8 and 10 years old. In 20 years they should be out of graduate school. Additionally, your financial adviser has determined that you need $1.5 million of coverage. A way to make the coverage affordable is to blend, say, a $1.0 million term policy that will end in 20 years with a $500,000 permanent policy of some type. As a result, that coverage will remain throughout one’s life and can be purchased in such a way that the death benefit rises through the years.
I see whole life as being most applicable in estate planning circumstances, where the guarantees matter and it is not appropriate to take any investment risk. It is also a good long-term CD alternative for funds that have no immediate use – much higher return than the CD, plus perhaps living benefits and a death benefit.
I’m also not a huge fan of Variable Universal Life for the average consumer. It works best for a younger insured (30 ish to 40 ish) who is comfortable with market risk and is working with an advisor who will help in the active choices of investment alternatives. Consequently, these policies need funding beyond the minimum needed to put the death benefit in place, to allow for the down years, as discussed in Part II.
I’ve had several years now to see how equity-income policies function, and I like what I see generally. The industry has developed other crediting indices (EAFE; S&P 100; etc.) and usually around policy anniversary time the owner can switch money around between various crediting buckets.
There are also great applications for plain vanilla universal life policies as well. Much of the interest rate risk is gone at this point in that generally the policies are now crediting at or near their contractual minimum rate, currently around 4% from what I see.
The Main Take Away
The main takeaway here is that when it comes to insurance, you need an advisor – even if you’re just picking up a cheap term policy off the internet. This is one of the times in life where you don’t know what you don’t know, and if you don’t do insurance correctly you can cause yourself big tax problems down the road. Here are three examples causing three different taxes to become payable:
You own a policy on yourself. Your wife is the beneficiary. You want to remove it from your taxable estate, so you assign it to her. She is now the owner and makes your children the beneficiaries. At your death, the policy will payout. The IRS will hold that your wife made taxable gifts to your children, and she may have to pay the gift tax, depending upon the amount paid out.
You have $5.49 million (2017) of assets. An insurance guy comes along and sells you a new $5.0 million policy. It sounds like a good idea – double your estate, and you can afford the premium. The children will get the benefit, with no income tax. But here’s the rub: instead of putting the policy in a trust, you own it outright, thereby causing the face amount of $5.0 million to be included in your taxable estate. At 40%, the estate tax due at your death is $2.0 million. Your children sue the insurance guy for negligence.
You decide you no longer need a policy and choose to surrender it: you need the cash. You may have caused yourself a big tax headache. When one surrenders a policy, there is income taxation at ordinary income rates of any gain over basis – the amount of the check you receive that’s more than the sum of all the premiums you paid in. This adds to your other income and runs you up the tax brackets.
Word to the wise: get all the coverage you need. Get good, competent advice. And remember that it is better to have lived well than to have died well.
Missed Part I and Part II? Go back and give them a read. And don’t miss my YouTube video, A Beginner’s Guide to Life Insurance. Please visit our website, CameronDowning, where you can see all of our blog posts and book an appointment to come see us. Please email questions to [email protected]
—Glenn J. Downing, MBA, CFP®