Most people recognize one need for life insurance: income protection for a family in case of the breadwinner’s untimely death. But many people are unfamiliar with the usefulness of life insurance as a tax-efficient way to transfer family wealth to the next generation. 

It’s first necessary to identify if and why you need life insurance to begin with. Then comes determining the type of life insurance that best suits your particular financial circumstances. 

At the time of purchase, a whole life policy represents the insurance company’s promise to provide coverage for the entire life of the insured person as long as premiums are paid. There is an investment component to the whole life policy.

Viewed strictly as an investment, a whole life policy from a quality company can compare favorably with other conservative vehicles, particularly due to the tax-deferred growth of the policy cash value.

Term life insurance, which doesn’t have an investment component, provides coverage for a specific length of time, the policy’s “term.” Whether, and at what cost, an expired term policy can be renewed for an additional period of coverage is another matter entirely.

Within each variety are many options and features to consider, and it can be a complicated process to sort through the available choices. Once you’ve figured out what you need, it’s wise to research and crunch numbers to find the best deal.

An alternative to the traditional whole life policy is the variable life policy, in which the investment component and return of the policy – not the insured person – varies. This is because the insured, not the insurance company, takes responsibility for selecting where the investment portion of the premium dollar goes.

Insurance policy benefits are paid directly to the beneficiary after death, so the named beneficiary gets the proceeds free of all taxes and doesn’t have to go through probate court. 

Life insurance benefits are considered as part of the estate of the deceased for federal estate tax purposes. One way around this is to make an irrevocable trust the owner of the policy. 

Insurance sales people like to say that a life insurance death benefit is purchased with “discounted dollars.” What they mean is that the annual premium will usually be only one to five percent of the policy face value, but that full amount is available from Day One. So life insurance is the only investment able to guarantee that a definite sum of cash will be available immediately. 

The “discounted dollars” concept allows you to transfer substantial wealth at reduced (or zero) gift tax cost. A program of yearly gifts, intended (but not required) to be used by your children for premiums, can take advantage of the annual $10,000 gift tax exclusion. That way, no tax is paid by anyone on those gifts, and your full federal gift and estate tax shelter is still available for use at your death. The certainty of the death benefit will produce a sizeable, predictable “instant” estate that can be quickly created and regularly increased with additional premium payments. 

The proper ownership of life insurance is critical to avoiding a variety of unwanted tax consequences. For example, without comprehensive planning, you can easily lose the advantage of income tax-free receipt of insurance proceeds by the beneficiary. For this reason, it’s particularly important to discuss your overall estate planning needs with a qualified attorney. 

 
Michael Palermo is a Lexington, Kentucky estate planning lawyer and Certified Financial Planner. More information about estate planning can be found on his Web site.