Life Insurance Planning
WHAT IS IT?
A life insurance policy is a contractual promise by an insurance company or beneficial association to pay a specified amount of money to a designated beneficiary when the insured person dies. The contract is between the insurance company and the policyowner who pays premiums in exchange for the promised death benefits. Frequently the policyowner is the person insured, but the policy can (and often should) be owned by someone, or some entity, other than the insured.
There are many variations on the theme but classically, the insurance company charges a premium for the contract that is combined with premium payments on other contracts into a general account of the insurance company. This general account, in addition to growth/ earnings on the investments, is designed to provide adequate funds to pay the promised death benefits as they come due and also cover insurance company expenses (and profits). Because a relatively small percentage of insureds actually die in any particular year, most of the policyowner premiums are collected in the general account and are saved (with accumulated growth) for payment as a death benefit in the (possibly distant) future. In addition, since most individuals will live many years before a claim must be paid, the insurance company will not only accumulate a large number of premiums over time, but will have a great deal of time to accumulate additional growth on the invested premiums. Consequently, the death benefit is almost always larger than the cumulative premium(s) paid for the individual policy (sometimes quite significantly so). Although on an individual basis, this could be a substantial loss for a company (in theory, a policyowner might make a single $1,000 payment, have the insured die, and $1,000,000 death benefit will be paid to the beneficiary), when the insurance company applies this pricing structure to a large number of policyowners, the individual fluctuations tend to offset each other and the inflows and outflows become extremely predictable when averaged over the aggregate.
There are different types of life insurance policies and they can be classified in different ways. The primary method of differentiating life insurance policies is as either term or permanent insurance. Term insurance is generally purchased for a certain (and limited) term of time, such as 5, 10, 20, or 30 years, or until age 70. Permanent insurance, on the other hand, is generally meant to be “permanent” – i.e., it can be kept in force as long as the insured lives, however long that may be. One defining characteristic of permanent insurance is that there is a “cash value” associated with the policy, and it may be available to some extent to the policyowner, either via a loan from the insurance company, or outright when the policy is surrendered.
Permanent insurance policies are typically separated into four distinct categories:
1. Whole life;
2. Interest-sensitive or current-assumption whole life;
3. Universal life; and
4. Variable life.
Each of these types of permanent life insurance (as well as term insurance) is discussed in detail in the Question and Answer portion of this chapter.
Another method of classification is by the number of lives insured. Most policies cover only one life, but policies are available that cover two or more lives. A joint life policy covers two individuals and pays a death benefit at the first death only; a joint survivorship (also called a 2nd-to-die or last-to-die) covers two individuals and is not payable until the death of the second (or last) of the insureds.
ADVANTAGES
1. Life insurance provides a guarantee of large amounts of cash payable immediately at the death of the insured. The amount of the death benefit payable is almost always significantly greater than the premiums paid for the policy. This is particularly true when the insured individual dies at a younger age – which is often the very situation in which insurance is needed the most in the greatest amount.
2. Life insurance proceeds are not part of the probate estate when policy proceeds are payable directly to a specific beneficiary other than the insured’s estate. Only when the estate is named as the beneficiary of the policy (or the proceeds are paid for the estate’s benefit) are the proceeds subject to probate. Therefore, the proceeds can be paid to the beneficiary without expense, delay, and aggravation caused by administration of the estate.
3. There will be no public record of the death benefit amount or to whom it is payable.
4. Life insurance policies offer protection against creditors of both the policyowner and of the beneficiary. The amount of protection varies from state to state but in many states it is significant.
5. Life insurance cash values provide virtually instant availability of cash through policy loans. The interest rate for policy loans is almost always lower than the rate on loans from other sources.
6. The death benefit proceeds from a life insurance policy are generally not subject to federal income taxes. (See the discussion of the transfer-for-value rules below for the exception of this general case.)
7. The increases in the cash value of a life insurance policy enjoy favorable federal income tax treatment. Interest earned on policy cash values is not taxable unless or until the policy is surrendered for cash. (See the discussion of the modified endowment contract rules below for the exception to this general rule.)
8. Life insurance proceeds are often exempt from state inheritance taxes. In Pennsylvania, for example, proceeds are exempt, even if payable to the insured’s estate. (But aside from a relatively small amount, life insurance proceeds paid to the insured’s estate is not recommended).
9. The guarantees and risk management provided by life insurance often brings peace of mind to the policyowner.
10. Permanent life insurance, with its cash value accumulations, can provide a method of “forced” savings (because premiums must be paid anyway or the policy may lapse) that aid individuals in long-term savings. However, it is important that life insurance “savings” not be made to the detriment of other, more appropriate, savings plans.
DISADVANTAGES
1. Life insurance is often not available to persons in extremely poor health. Individuals in moderately poor health can almost always obtain insurance if they are willing to pay higher premiums. These extra charges, to take into consideration the extra risk assumed by the insurance company, are called “ratings.”
2. Life insurance is a complex product that is hard to evaluate and compare. The time required to gather policy information, decipher it, and compare it with other policies discourages purchasers from engaging in comparison shopping for many types of insurance.
3. The cost of coverage reduces the amount of funds available for current consumption or investment for the future.
TAX IMPLICATIONS
1. In general no tax deduction is permitted for premium payments on life insurance policies. The notable exception is that the premium payment on group term life insurance provided by an employer to employees is income tax deductible.
2. Dividends received by the policyowner on a mutual policy are considered a return of premium – repayments of this nature are generally not subject to federal income taxation. Dividends will not be taxable income unless the aggregate of dividends paid (and other amounts withdrawn) exceeds the aggregate of premiums paid by the policyowner. However, income tax free dividend distributions do reduce the cost basis of the life insurance policy for future gain/loss determinations.
3. The cash value increases on an in-force life insurance policy resulting from investment income are not taxable income. The cash value build-up in a life insurance policy enjoys deferral from taxation while the policy remains in force and is exempt from income tax if the policy terminates in a death claim. However, if the policy is surrendered for cash, the gain on the policy is subject to federal income taxation. The gain on a surrendered policy is the amount by which the sum of the net cash value payable and policy loan forgiveness exceeds the owner’s basis in the policy. The character of any gains are ordinary income rather than capital gains. Because life insurance policies are personal property that are not held for investment, losses are not deductible.
Basis in the policy equals the premiums paid less policyowner dividends and less any other amounts previously withdrawn. For example, a policy on which $35,000 has been paid in premiums and $7,000 has been received in dividends would have a basis of $28,000 ($35,000 – $7,000 = $28,000). If that policy were surrendered for $10,000 in cash and a policy loan of $50,000 canceled (as if a total of $60,000 was received at the time of surrender), there would be an ordinary income taxable gain of $32,000 ($60,000 – 28,000 = $32,000).
4. The death benefits payable under a life insurance policy are generally free from federal income taxation. Proceeds from corporate-owned life insurance policies can increase “adjusted current earnings” (ACE), a portion of which may be taxed under the corporate “alternative minimum tax” (AMT). In a worst case scenario, this tax amounts to roughly 15% of the total policy proceeds paid to a corporate beneficiary. The AMT system is basically an alternative tax system that calculates taxes due under a separate tax structure – in any particular year, the corporation pays the higher of the regular tax bill or the AMT system tax bill. The AMT system does not allow tax deductions or exclusions for certain items that receive preferential treatment under the regular income tax rules. The AMT is generally applicable only if there are large amounts of preferentially treated items relative to the regular corporate income tax. Consequently, it is possible that the AMT will not apply if the death benefit proceeds are paid in a year when there are few other preference items. Additionally, after 1997, corporations meeting the definition of a “small corporation” are exempt from the AMT. A small corporation is generally one which has average annual gross receipts for the previous three years that do not exceed $7,500,000 ($5,000,000 for a new small corporation’s first three years, and never applicable in the first year of a corporation’s existence).
5. Unless certain requirements are met, the death benefits payable under an employer-owned life insurance contract will be included in the employer’s income to the extent the death proceeds exceed the amounts that were paid for the policy (including premiums). One set of requirements is that before an employer-owned life insurance contract is issued the employer must meet certain notice and consent requirements. The insured employee must be notified in writing that the employer intends to insure the employee’s life, and the maximum face amount the employee’s life could be insured for at the time the contract is issued. The notice must also state that the policy owner will be the beneficiary of the death proceeds of the policy. The insured must also give written consent to be the insured under the contract and consent to coverage continuing after the insured terminates employment.
Another set of requirements regards the insured’s status with the employer. The insured must have been an employee at any time during the 12-month period before his death, or at the time the contract was issued was a director or highly compensated employee. A highly compensated employee is an employee classified as highly compensated under the qualified plan rules of Code section 414(q) (except for the election regarding the top paid group), or under the rules regarding self-insured medical expense reimbursement plans of Code section 105(h), except that the highest paid 35 percent instead of 25 percent will be considered highly compensated. Alternatively, the death proceeds of employer-owned life insurance will not be included in the employer’s income (assuming the notice and consent requirements are met) if the amount is paid to a member of the insured’s family (defined as a sibling, spouse, ancestor, or lineal descendent), any individual who is the designated beneficiary of the insured under the contract (other than the policy owner), a trust that benefits a member of the family or designated beneficiary, or the estate of the insured. If the death proceeds are used to purchase an equity interest from a family member, beneficiary, trust, or estate, the proceeds will not be included in the employer’s income.
In addition, the Act imposes new reporting requirements on all employers owning one or more employer-owned life insurance contracts. These provisions regarding employer-owned life insurance are effective for life insurance contracts issued after August 17, 2006, except for contracts issued in a 1035 exchange where there was not a material increase in the death benefit or other material change.
6. Life insurance policies that have been transferred by one policyowner to another may be subject to the transfer-for-value rule. Under this rule, the death proceeds of a policy transferred to certain non-exempt parties for a valuable consideration are taxed as ordinary income to the extent the death proceeds are greater than the purchase price plus premiums and certain interest amounts relating to policy indebtedness paid by the transferee.
In other words, if an existing life insurance policy or an interest in an existing policy is transferred for any type of valuable consideration in money or money’s worth, all or a significant portion of the death benefit proceeds may lose income-tax-free status. However, policies can be transferred safely to certain parties that are exempt from the transfer-for-value rules, including:
a. The insured;
b. A partner of the insured;
c. A partnership in which the insured is a partner;
d. A corporation in which the insured is a shareholder or officer; or
e. Any party whose basis is determined by reference to the original transferor’s basis (e.g., a gift transfer).
7. The proceeds of a life insurance policy will be included in the estate of the insured for federal estate tax purposes if the insured held any “incident of ownership” at death or at any time during the three years prior to death, or if the proceeds from the policy were payable to or for the benefit of the estate of the insured. Incidents of ownership include such things as the right to: (a) change the beneficiary; (b) take out a policy loan; (c) surrender the policy for cash; or (d) pledge the policy for a loan.
8. Distributions such as cash withdrawals or policy loans from a life insurance policy classified as a modified endowment contract (MEC) may be taxed differently than if the policy is not so classified. If a policy entered into after June 21, 1988, falls into this category by failing the seven-pay test, distributions from the policy will be taxed less favorably than if the seven-pay test is met.
A policy fails the seven-pay test if the cumulative amount paid at any time during the first seven years of the contract exceeds the net level premiums that would have been paid during the first seven years if the contract provided for paid-up future benefits. If a material change in the policy’s benefits occurs, a new seven-year period for testing must begin, which can potentially cause a policy to fail the MEC test, despite initially being exempt as a policy issued before June 21, 1988. Once a life insurance policy becomes a modified endowment contract, it remains so for the duration of the policy.
Distributions, including policy loans, from modified endowment contracts are taxed as income at the time received to the extent that the cash value of the contract immediately before the payment exceeds the investment in the contract. In effect, this means that policy distributions are taxed as income first and recovery of basis second, much as distributions from annuity contracts are taxed. Additionally, a penalty tax of 10% applies to distribution amounts included in income unless the taxpayer has become disabled, or reached age 59-1/2 or the distribution is part of a series of substantially equal payments made over the taxpayer’s life. However, proceeds from a MEC paid as a death claim still enjoy the tax-exempt status of life insurance.
For the purpose of determining the amount includable in gross income, all modified endowment contracts issued by the same company to the same policyholder during any calendar year are treated as one modified endowment contract.
WHAT FEES OR OTHER ACQUISITION COSTS ARE INVOLVED?
Life insurance is generally sold on a specified price basis. Life insurance companies are free to set their premiums according to their own marketing strategies. All but a few states have statutes prohibiting any form of “rebating” by the agent (sharing the commission with the purchaser, or reducing the cost of the insurance for the buyer via the agent giving up a portion of the commission). The premium set by the insurance company includes a “loading” (a specified part of each premium payment) to cover such things as commission payments to agents, premium taxes payable to the state government, operating expenses of the insurance company such as rent or mortgage payments and salaries, any other applicable expenses, and a profit margin for the insurance company.
There are some life insurance companies that sell “no load” life insurance policies. These policies do not provide a commission to the selling agent. However, these companies tend to price in a cost premium that approximates the charge by those companies who do pay commissions to agents – the additional cost premium is generally used to cover other marketing costs which are necessary to secure sales to consumers when commissioned insurance agents are not used. These costs often bring the total loading up by an equal amount to the reduction in costs from commission savings – thus, the total loading (and thus the total cost) tends to be similar, whether using a “no load” insurance policy or not. However, for individuals who seek not to work with a commissioned individual, this still provides an alternative (although not necessarily cheaper) life insurance purchase experience. There are also opportunities for direct negotiation of premiums with the insurance company in the case of a private placement ultra large ($10,000,000 or greater) policy.
The bulk of an insurance company’s expenses for a policy are incurred during the year the policy is issued. It may take an insurance company five to nine years or even longer to recover all of its front-end costs. These front-end costs include not only the commission paid to the insurance agent, but also the internal costs for the entire underwriting process (such as ordering the medical evaluation and physician statement and examining records and the insurance application) and the administrative work necessary to add the new policyowner to the system.
The state premium tax applicable to all life insurance premium payments is an ongoing expense. The average level of this tax (which varies from state to state) is about 2 1/2% of each premium payment.
With most cash value policies, the aggregate of commissions payable to the selling agent is approximately equal to the first year premium on the policy. About half of it is payable in the year of sale and the other half will be paid on a renewal basis over a period of three to nine years. On single premium policies (where the entire cost for the policy is paid at once rather than over time) the commission payable usually ranges between 2 to 8% of the premium. Commissions are usually paid in a similar manner on term insurance policies as they are on cash-value policies, but the premium/commission amounts tend to be significantly smaller (resulting in a smaller total commission per sale), and the commission is often even more front-loaded (possibly 75% to 100% of the first-year premium paid as a commission with no renewals in subsequent years).
APPROPRIATE TYPES OF POLICIES
There is often no such thing as a single “best” policy or type of policy for a particular client since there may be many policies that will be appropriate and competitively priced. But the policies that the planner should consider should meet certain criteria. Factors to consider include:
1. Total death benefit required;
2. Duration of the need;
3. The preferences of the client as to living benefits;
4. The amount of premiums the client can afford and the client’s cash-flow abilities and timing preferences;
5. The type and amount of investment and other risk the client is willing to assume (or guarantees the client demands or is willing to give up) in return for potential enhanced cash value, dividend, and death benefits.
Some generally accepted rule-of-thumb guidelines in policy selection are:
1. For durations of 10 years or less, term insurance is usually appropriate;
2. For durations between 10 and 15 years, both term insurance and cash value coverage should be evaluated;
3. For durations in excess of 15 years or when it is impossible to ascertain how long coverage will be needed, cash value forms of coverage are usually more cost effective than term;
4. Clients who prefer maximum premium flexibility and death benefit flexibility will want to consider some form or combination of universal life and variable universal life;
5. Clients preferring to direct the investments behind the policy and who are willing to assume the investment risk will want to consider variable life insurance (such as variable universal life or variable whole life); and
6. Clients desiring a maximum of guarantees and a minimum of risk assumption will prefer the more traditional contracts such as whole life and level term.
Individual preferences relative to “pre-funding” (paying higher payments at the beginning in order to avoid payment increases in later years) or “pay-as-you-go” (paying the lowest possible price initially subject to substantial increases with age) will influence the premium paying pattern appropriate for the client. Clients willing and able to pre-fund totally may consider single premium policies, while those who are willing to pre-fund only partially generally prefer level premium payments for a specified period. Clients not willing to pre-fund life insurance will purchase annual renewable term insurance and pay increasing premiums at each renewal of the term coverage. Pre-funding of life insurance may result in increased policy cash values. The tax-deferred earnings on those cash values help defray or eliminate the future premium needs of the policy.
Specific Policies
Selecting a specific policy involves a combination of factors that include:
1. An evaluation of the insurance company’s financial soundness; and
2. A comparison of policy guarantees and projections (benefit promises).
The company should generally have one of the highest ratings from one or more of the following companies: A.M. Best Company, Standard & Poor’s, Moody’s Investor’s Service, Fitch, Inc., or Weiss Research, Inc. The company should also have a reputation for prompt and courteous service in handling policy changes and claims. It is important to give close attention to the full name and city of domicile for insurance companies as many of them have very similar names. Companies that do business in New York State are generally subject to more comprehensive consumer protection laws than companies that are not licensed there.
The agent should have experience with life insurance, as it is used for the particular needs situation of the client, a minimum of 3 years experience, and be well versed in both insurance knowledge and tax knowledge at the federal and state levels. He or she should have, or be working on obtaining, a CFP®, CLU, or ChFC designation.
For more Information:
Insurance Planning Resources
Businessowners Policy Coverage Guide, Commercial General Liability Coverage Guide, Employment Practices Liability, Insurance—Life, Health and Disability
WHAT IS IT?
A life insurance policy is a contractual promise by an insurance company or beneficial association to pay a specified amount of money to a designated beneficiary when the insured person dies. The contract is between the insurance company and the policyowner who pays premiums in exchange for the promised death benefits. Frequently the policyowner is the person insured, but the policy can (and often should) be owned by someone, or some entity, other than the insured.
There are many variations on the theme but classically, the insurance company charges a premium for the contract that is combined with premium payments on other contracts into a general account of the insurance company. This general account, in addition to growth/ earnings on the investments, is designed to provide adequate funds to pay the promised death benefits as they come due and also cover insurance company expenses (and profits). Because a relatively small percentage of insureds actually die in any particular year, most of the policyowner premiums are collected in the general account and are saved (with accumulated growth) for payment as a death benefit in the (possibly distant) future. In addition, since most individuals will live many years before a claim must be paid, the insurance company will not only accumulate a large number of premiums over time, but will have a great deal of time to accumulate additional growth on the invested premiums. Consequently, the death benefit is almost always larger than the cumulative premium(s) paid for the individual policy (sometimes quite significantly so). Although on an individual basis, this could be a substantial loss for a company (in theory, a policyowner might make a single $1,000 payment, have the insured die, and $1,000,000 death benefit will be paid to the beneficiary), when the insurance company applies this pricing structure to a large number of policyowners, the individual fluctuations tend to offset each other and the inflows and outflows become extremely predictable when averaged over the aggregate.
There are different types of life insurance policies and they can be classified in different ways. The primary method of differentiating life insurance policies is as either term or permanent insurance. Term insurance is generally purchased for a certain (and limited) term of time, such as 5, 10, 20, or 30 years, or until age 70. Permanent insurance, on the other hand, is generally meant to be “permanent” – i.e., it can be kept in force as long as the insured lives, however long that may be. One defining characteristic of permanent insurance is that there is a “cash value” associated with the policy, and it may be available to some extent to the policyowner, either via a loan from the insurance company, or outright when the policy is surrendered.
Permanent insurance policies are typically separated into four distinct categories:
1. Whole life;
2. Interest-sensitive or current-assumption whole life;
3. Universal life; and
4. Variable life.
Each of these types of permanent life insurance (as well as term insurance) is discussed in detail in the Question and Answer portion of this chapter.
Another method of classification is by the number of lives insured. Most policies cover only one life, but policies are available that cover two or more lives. A joint life policy covers two individuals and pays a death benefit at the first death only; a joint survivorship (also called a 2nd-to-die or last-to-die) covers two individuals and is not payable until the death of the second (or last) of the insureds.
ADVANTAGES
1. Life insurance provides a guarantee of large amounts of cash payable immediately at the death of the insured. The amount of the death benefit payable is almost always significantly greater than the premiums paid for the policy. This is particularly true when the insured individual dies at a younger age – which is often the very situation in which insurance is needed the most in the greatest amount.
2. Life insurance proceeds are not part of the probate estate when policy proceeds are payable directly to a specific beneficiary other than the insured’s estate. Only when the estate is named as the beneficiary of the policy (or the proceeds are paid for the estate’s benefit) are the proceeds subject to probate. Therefore, the proceeds can be paid to the beneficiary without expense, delay, and aggravation caused by administration of the estate.
3. There will be no public record of the death benefit amount or to whom it is payable.
4. Life insurance policies offer protection against creditors of both the policyowner and of the beneficiary. The amount of protection varies from state to state but in many states it is significant.
5. Life insurance cash values provide virtually instant availability of cash through policy loans. The interest rate for policy loans is almost always lower than the rate on loans from other sources.
6. The death benefit proceeds from a life insurance policy are generally not subject to federal income taxes. (See the discussion of the transfer-for-value rules below for the exception of this general case.)
7. The increases in the cash value of a life insurance policy enjoy favorable federal income tax treatment. Interest earned on policy cash values is not taxable unless or until the policy is surrendered for cash. (See the discussion of the modified endowment contract rules below for the exception to this general rule.)
8. Life insurance proceeds are often exempt from state inheritance taxes. In Pennsylvania, for example, proceeds are exempt, even if payable to the insured’s estate. (But aside from a relatively small amount, life insurance proceeds paid to the insured’s estate is not recommended).
9. The guarantees and risk management provided by life insurance often brings peace of mind to the policyowner.
10. Permanent life insurance, with its cash value accumulations, can provide a method of “forced” savings (because premiums must be paid anyway or the policy may lapse) that aid individuals in long-term savings. However, it is important that life insurance “savings” not be made to the detriment of other, more appropriate, savings plans.
DISADVANTAGES
1. Life insurance is often not available to persons in extremely poor health. Individuals in moderately poor health can almost always obtain insurance if they are willing to pay higher premiums. These extra charges, to take into consideration the extra risk assumed by the insurance company, are called “ratings.”
2. Life insurance is a complex product that is hard to evaluate and compare. The time required to gather policy information, decipher it, and compare it with other policies discourages purchasers from engaging in comparison shopping for many types of insurance.
3. The cost of coverage reduces the amount of funds available for current consumption or investment for the future.
TAX IMPLICATIONS
1. In general no tax deduction is permitted for premium payments on life insurance policies. The notable exception is that the premium payment on group term life insurance provided by an employer to employees is income tax deductible.
2. Dividends received by the policyowner on a mutual policy are considered a return of premium – repayments of this nature are generally not subject to federal income taxation. Dividends will not be taxable income unless the aggregate of dividends paid (and other amounts withdrawn) exceeds the aggregate of premiums paid by the policyowner. However, income tax free dividend distributions do reduce the cost basis of the life insurance policy for future gain/loss determinations.
3. The cash value increases on an in-force life insurance policy resulting from investment income are not taxable income. The cash value build-up in a life insurance policy enjoys deferral from taxation while the policy remains in force and is exempt from income tax if the policy terminates in a death claim. However, if the policy is surrendered for cash, the gain on the policy is subject to federal income taxation. The gain on a surrendered policy is the amount by which the sum of the net cash value payable and policy loan forgiveness exceeds the owner’s basis in the policy. The character of any gains are ordinary income rather than capital gains. Because life insurance policies are personal property that are not held for investment, losses are not deductible.
Basis in the policy equals the premiums paid less policyowner dividends and less any other amounts previously withdrawn. For example, a policy on which $35,000 has been paid in premiums and $7,000 has been received in dividends would have a basis of $28,000 ($35,000 – $7,000 = $28,000). If that policy were surrendered for $10,000 in cash and a policy loan of $50,000 canceled (as if a total of $60,000 was received at the time of surrender), there would be an ordinary income taxable gain of $32,000 ($60,000 – 28,000 = $32,000).
4. The death benefits payable under a life insurance policy are generally free from federal income taxation. Proceeds from corporate-owned life insurance policies can increase “adjusted current earnings” (ACE), a portion of which may be taxed under the corporate “alternative minimum tax” (AMT). In a worst case scenario, this tax amounts to roughly 15% of the total policy proceeds paid to a corporate beneficiary. The AMT system is basically an alternative tax system that calculates taxes due under a separate tax structure – in any particular year, the corporation pays the higher of the regular tax bill or the AMT system tax bill. The AMT system does not allow tax deductions or exclusions for certain items that receive preferential treatment under the regular income tax rules. The AMT is generally applicable only if there are large amounts of preferentially treated items relative to the regular corporate income tax. Consequently, it is possible that the AMT will not apply if the death benefit proceeds are paid in a year when there are few other preference items. Additionally, after 1997, corporations meeting the definition of a “small corporation” are exempt from the AMT. A small corporation is generally one which has average annual gross receipts for the previous three years that do not exceed $7,500,000 ($5,000,000 for a new small corporation’s first three years, and never applicable in the first year of a corporation’s existence).
5. Unless certain requirements are met, the death benefits payable under an employer-owned life insurance contract will be included in the employer’s income to the extent the death proceeds exceed the amounts that were paid for the policy (including premiums). One set of requirements is that before an employer-owned life insurance contract is issued the employer must meet certain notice and consent requirements. The insured employee must be notified in writing that the employer intends to insure the employee’s life, and the maximum face amount the employee’s life could be insured for at the time the contract is issued. The notice must also state that the policy owner will be the beneficiary of the death proceeds of the policy. The insured must also give written consent to be the insured under the contract and consent to coverage continuing after the insured terminates employment.
Another set of requirements regards the insured’s status with the employer. The insured must have been an employee at any time during the 12-month period before his death, or at the time the contract was issued was a director or highly compensated employee. A highly compensated employee is an employee classified as highly compensated under the qualified plan rules of Code section 414(q) (except for the election regarding the top paid group), or under the rules regarding self-insured medical expense reimbursement plans of Code section 105(h), except that the highest paid 35 percent instead of 25 percent will be considered highly compensated. Alternatively, the death proceeds of employer-owned life insurance will not be included in the employer’s income (assuming the notice and consent requirements are met) if the amount is paid to a member of the insured’s family (defined as a sibling, spouse, ancestor, or lineal descendent), any individual who is the designated beneficiary of the insured under the contract (other than the policy owner), a trust that benefits a member of the family or designated beneficiary, or the estate of the insured. If the death proceeds are used to purchase an equity interest from a family member, beneficiary, trust, or estate, the proceeds will not be included in the employer’s income.
In addition, the Act imposes new reporting requirements on all employers owning one or more employer-owned life insurance contracts. These provisions regarding employer-owned life insurance are effective for life insurance contracts issued after August 17, 2006, except for contracts issued in a 1035 exchange where there was not a material increase in the death benefit or other material change.
6. Life insurance policies that have been transferred by one policyowner to another may be subject to the transfer-for-value rule. Under this rule, the death proceeds of a policy transferred to certain non-exempt parties for a valuable consideration are taxed as ordinary income to the extent the death proceeds are greater than the purchase price plus premiums and certain interest amounts relating to policy indebtedness paid by the transferee.
In other words, if an existing life insurance policy or an interest in an existing policy is transferred for any type of valuable consideration in money or money’s worth, all or a significant portion of the death benefit proceeds may lose income-tax-free status. However, policies can be transferred safely to certain parties that are exempt from the transfer-for-value rules, including:
a. The insured;
b. A partner of the insured;
c. A partnership in which the insured is a partner;
d. A corporation in which the insured is a shareholder or officer; or
e. Any party whose basis is determined by reference to the original transferor’s basis (e.g., a gift transfer).
7. The proceeds of a life insurance policy will be included in the estate of the insured for federal estate tax purposes if the insured held any “incident of ownership” at death or at any time during the three years prior to death, or if the proceeds from the policy were payable to or for the benefit of the estate of the insured. Incidents of ownership include such things as the right to: (a) change the beneficiary; (b) take out a policy loan; (c) surrender the policy for cash; or (d) pledge the policy for a loan.
8. Distributions such as cash withdrawals or policy loans from a life insurance policy classified as a modified endowment contract (MEC) may be taxed differently than if the policy is not so classified. If a policy entered into after June 21, 1988, falls into this category by failing the seven-pay test, distributions from the policy will be taxed less favorably than if the seven-pay test is met.
A policy fails the seven-pay test if the cumulative amount paid at any time during the first seven years of the contract exceeds the net level premiums that would have been paid during the first seven years if the contract provided for paid-up future benefits. If a material change in the policy’s benefits occurs, a new seven-year period for testing must begin, which can potentially cause a policy to fail the MEC test, despite initially being exempt as a policy issued before June 21, 1988. Once a life insurance policy becomes a modified endowment contract, it remains so for the duration of the policy.
Distributions, including policy loans, from modified endowment contracts are taxed as income at the time received to the extent that the cash value of the contract immediately before the payment exceeds the investment in the contract. In effect, this means that policy distributions are taxed as income first and recovery of basis second, much as distributions from annuity contracts are taxed. Additionally, a penalty tax of 10% applies to distribution amounts included in income unless the taxpayer has become disabled, or reached age 59-1/2 or the distribution is part of a series of substantially equal payments made over the taxpayer’s life. However, proceeds from a MEC paid as a death claim still enjoy the tax-exempt status of life insurance.
For the purpose of determining the amount includable in gross income, all modified endowment contracts issued by the same company to the same policyholder during any calendar year are treated as one modified endowment contract.
WHAT FEES OR OTHER ACQUISITION COSTS ARE INVOLVED?
Life insurance is generally sold on a specified price basis. Life insurance companies are free to set their premiums according to their own marketing strategies. All but a few states have statutes prohibiting any form of “rebating” by the agent (sharing the commission with the purchaser, or reducing the cost of the insurance for the buyer via the agent giving up a portion of the commission). The premium set by the insurance company includes a “loading” (a specified part of each premium payment) to cover such things as commission payments to agents, premium taxes payable to the state government, operating expenses of the insurance company such as rent or mortgage payments and salaries, any other applicable expenses, and a profit margin for the insurance company.
There are some life insurance companies that sell “no load” life insurance policies. These policies do not provide a commission to the selling agent. However, these companies tend to price in a cost premium that approximates the charge by those companies who do pay commissions to agents – the additional cost premium is generally used to cover other marketing costs which are necessary to secure sales to consumers when commissioned insurance agents are not used. These costs often bring the total loading up by an equal amount to the reduction in costs from commission savings – thus, the total loading (and thus the total cost) tends to be similar, whether using a “no load” insurance policy or not. However, for individuals who seek not to work with a commissioned individual, this still provides an alternative (although not necessarily cheaper) life insurance purchase experience. There are also opportunities for direct negotiation of premiums with the insurance company in the case of a private placement ultra large ($10,000,000 or greater) policy.
The bulk of an insurance company’s expenses for a policy are incurred during the year the policy is issued. It may take an insurance company five to nine years or even longer to recover all of its front-end costs. These front-end costs include not only the commission paid to the insurance agent, but also the internal costs for the entire underwriting process (such as ordering the medical evaluation and physician statement and examining records and the insurance application) and the administrative work necessary to add the new policyowner to the system.
The state premium tax applicable to all life insurance premium payments is an ongoing expense. The average level of this tax (which varies from state to state) is about 2 1/2% of each premium payment.
With most cash value policies, the aggregate of commissions payable to the selling agent is approximately equal to the first year premium on the policy. About half of it is payable in the year of sale and the other half will be paid on a renewal basis over a period of three to nine years. On single premium policies (where the entire cost for the policy is paid at once rather than over time) the commission payable usually ranges between 2 to 8% of the premium. Commissions are usually paid in a similar manner on term insurance policies as they are on cash-value policies, but the premium/commission amounts tend to be significantly smaller (resulting in a smaller total commission per sale), and the commission is often even more front-loaded (possibly 75% to 100% of the first-year premium paid as a commission with no renewals in subsequent years).
APPROPRIATE TYPES OF POLICIES
There is often no such thing as a single “best” policy or type of policy for a particular client since there may be many policies that will be appropriate and competitively priced. But the policies that the planner should consider should meet certain criteria. Factors to consider include:
1. Total death benefit required;
2. Duration of the need;
3. The preferences of the client as to living benefits;
4. The amount of premiums the client can afford and the client’s cash-flow abilities and timing preferences;
5. The type and amount of investment and other risk the client is willing to assume (or guarantees the client demands or is willing to give up) in return for potential enhanced cash value, dividend, and death benefits.
Some generally accepted rule-of-thumb guidelines in policy selection are:
1. For durations of 10 years or less, term insurance is usually appropriate;
2. For durations between 10 and 15 years, both term insurance and cash value coverage should be evaluated;
3. For durations in excess of 15 years or when it is impossible to ascertain how long coverage will be needed, cash value forms of coverage are usually more cost effective than term;
4. Clients who prefer maximum premium flexibility and death benefit flexibility will want to consider some form or combination of universal life and variable universal life;
5. Clients preferring to direct the investments behind the policy and who are willing to assume the investment risk will want to consider variable life insurance (such as variable universal life or variable whole life); and
6. Clients desiring a maximum of guarantees and a minimum of risk assumption will prefer the more traditional contracts such as whole life and level term.
Individual preferences relative to “pre-funding” (paying higher payments at the beginning in order to avoid payment increases in later years) or “pay-as-you-go” (paying the lowest possible price initially subject to substantial increases with age) will influence the premium paying pattern appropriate for the client. Clients willing and able to pre-fund totally may consider single premium policies, while those who are willing to pre-fund only partially generally prefer level premium payments for a specified period. Clients not willing to pre-fund life insurance will purchase annual renewable term insurance and pay increasing premiums at each renewal of the term coverage. Pre-funding of life insurance may result in increased policy cash values. The tax-deferred earnings on those cash values help defray or eliminate the future premium needs of the policy.
Specific Policies
Selecting a specific policy involves a combination of factors that include:
1. An evaluation of the insurance company’s financial soundness; and
2. A comparison of policy guarantees and projections (benefit promises).
The company should generally have one of the highest ratings from one or more of the following companies: A.M. Best Company, Standard & Poor’s, Moody’s Investor’s Service, Fitch, Inc., or Weiss Research, Inc. The company should also have a reputation for prompt and courteous service in handling policy changes and claims. It is important to give close attention to the full name and city of domicile for insurance companies as many of them have very similar names. Companies that do business in New York State are generally subject to more comprehensive consumer protection laws than companies that are not licensed there.
The agent should have experience with life insurance, as it is used for the particular needs situation of the client, a minimum of 3 years experience, and be well versed in both insurance knowledge and tax knowledge at the federal and state levels. He or she should have, or be working on obtaining, a CFP®, CLU, or ChFC designation.
For more Information:
Insurance Planning Resources
Businessowners Policy Coverage Guide, Commercial General Liability Coverage Guide, Employment Practices Liability, Insurance—Life, Health and Disability
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