Life Insurance and Why People Buy It
According to the U.S. Census Bureau, Statistical Abstract of the United States, 2012, there were 291 million life insurance policies in the United States at the end of 2009, totaling 18.1 trillion dollars. Life insurance and other insurance products play an enormous role in the lives of millions of Americans, both before and after retirement.
5 Special Things
Life insurance has several notable features: 1. For a relatively small premium, life insurance can provide a large lump sum to the beneficiaries. 2. The death benefit comes exactly when it is needed. 3. Death proceeds are not normally taxable to the beneficiary. 4. Death proceeds are usually not subject to probate. and 5. In many states, life insurance policies are not subject to the claims of creditors. Please consult a CPA about #3 and an attorney about #4 and #5 in your specific state.
5 Reasons People Buy It
#1 - Death of the Breadwinner: It is simple to figure out how much life insurance a family requires. First, add up all the things that would require a lump sum payment if the breadwinner died. How much is owed on cars, the house, the boat, credit cards or business loans? Are there children or grandchildren who will need financial support for their college education? How much extra cash is needed in an emergency fund? How much is needed for the final expenses of the deceased (like medical bills, funeral expenses and legal bills)? Let’s assume the total of these outlays is $200,000. Second, how much income will be lost if the breadwinner died? Take that annual number and divide it by 4%. This math will tell us the cash lump sum that needs to “show up” and “go to work” in his place. If, for example, the breadwinner made $40,000, then $1,000,000 would be needed to replace his earning capacity ($40,000 divided by 4% = $1,000,000). When we add the two totals together, $1,200,000 would be called for in life insurance. Besides being a useful tool for working families, this formula can also be used by retirees to assess their need for existing life policies. Often, life insurance policies can be surrendered or converted to other products for retirement income. Situations will vary considerably, but this is a good starting point.
#2 - Pay-off Debt or Secure a Loan: Many people do not want to leave their survivors in debt, so they buy life insurance. The husband of one of my clients recently passed away. He had wisely purchased a life insurance policy that was big enough to pay-off their mortgage. Despite her grief, my client was comforted by his prudent planning, which left her unburdened by a mortgage for the rest of her life.
Life insurance is often required as one of the conditions of a bank loan. In 2010, I consolidated my financial and investment offices into one permanent location in Ormond Beach, Florida. We completely remodeled the second floor of an existing building to suit our needs. As you can imagine, the costs were significant, so we made arrangements with a local bank to cover the costs of the demolition and reconstruction. As part of the financing package, the bank required life insurance on me in an amount equal to the loan, just in case I didn’t live long enough to repay the loan.
#3 - Fund the Buy-Sell Agreements between Business Partners: Most buy-sell agreements will call for the purchase of life insurance on each business partner by the other. This assures that money is available for the surviving partner to buy the deceased partner’s share of the business from his heirs. Without an agreement and life insurance in place, a business owner might find himself with an unexpected new partner, his previous partner’s widow! Term insurance is often used because it is relatively cheap. The cost is considered by many business owners to be a prudent expenditure.
#4 - Pension Maximization: One of the biggest decisions that some lucky retirees get to make is how they will take their pensions. Often, they have a choice between getting payments for a single or a joint lifetime. The joint pension is obviously better for the spouse, but that monthly check can be a lot less than the single pension amount. Unless there is a health condition that will likely shorten the life of one of the spouses, the single versus joint pension decision can be a tough one to make.
Life insurance is sometimes used as part of a “pension maximization” strategy to resolve the single versus joint life decision. In this strategy, the pensioner takes the single life pension. The pensioner then buys a life insurance policy with some of the “extra” pension income that is coming in from the higher single life payment. The net pension is higher, even after deducting the cost of the life insurance, than what the joint life pension would have been. In the event the pensioner dies early, the spouse gets the life insurance. Sometimes this strategy isn’t the best choice, like when the pensioner is in poor health or is too young. It is critical to run the numbers to see what produces the best outcome.
#5 - Transfer Wealth to the Next Generation: There are many well-established financial strategies that can help families reduce income and estate taxes so that more money can be transferred from one generation to the next. Some of them use life insurance. Here is just one example: Let’s say a father has a $100,000 IRA that he wants to leave to his daughter. He’s 71 and is only taking the required minimum distributions each year. If the father buys an annuity with the IRA, he will get a predictable income for his lifetime. After setting aside cash for taxes, the annuity payments can then be used to pay the annual premiums on a $200,000 life insurance policy. When he dies, the daughter will get the life insurance income tax-free! If instead, the father had left the IRA to his daughter, any withdrawals would be taxable income on top of her other income. Tax-free beats taxable-on-top-of-other-income-and-probably-at-a-higher-tax-bracket, any day of the week.
Life insurance isn’t for everyone, nor is it always needed. Consult a licensed, independent insurance agent for advice. Next week, we’ll discuss the choice between term and permanent life insurance.
David D. Holland, a CERTIFIED FINANCIAL PLANNER™ practitioner, hosts a weekday radio show at 9AM on AM1380 Ormond Beach, AM1230 New Smyrna Beach and AM1490 Deland. He has also authored two books in his Confessions of a Financial Planner series. Holland offers investment advice through Holland Advisory Services, Inc., a registered investment adviser in Ormond Beach. He can be contacted at (386) 671-7526. Email your financial questions to info@DavidHolland.com.