The Need for Life Insurance
Most people benefit from having life insurance. It is just a question of what type of life insurance best fits your needs and circumstances.
Having life insurance can give you peace of mind that if something were to happen to you, your family would be able to pay the mortgage, tuition expenses, and other large expenses while maintaining the same standard of living. Insurance is not a betting game. Chances are that you should have life insurance, but insurance consumers frequently feel pressure to buy more than they need.
How Much Life Insurance Do I Really Need?
Perhaps the soundest approach to purchasing life insurance is to consider personal needs. When you talk to your financial advisor about life insurance, be sure to consider the following basic uses for life insurance.
Income Replacement
Life insurance can replace lost income for someone who dies unexpectedly. For example, what funds will be available to the surviving family members to pay everyday bills? In determining the amount of life insurance necessary for income replacement, consider the following needs:
- a transition fund to pay at least six months’ of bills during the grieving period
- an emergency fund for a catastrophic illness or injury, sudden and unexpected accident or casualty, financial collapse, or the like
- funds to pay off mortgages and other debts
- funds to supplement or replace Social Security
If you have young children, also consider an amount sufficient for child-rearing, tuition for education like college and postgraduate expenses, career help, and even the cost of marriages or assisting children to buy a first home.
Planning Tip: Consider life insurance to replace income from the premature death of a breadwinner spouse or parent. The amount of insurance necessary should take into consideration not only monthly living expenses, but also transition and emergency funds, plus child-related expenses.
Wealth Replacement
One wealth replacement use of life insurance is to replace wealth lost to the federal estate tax. However, in recent years, the federal estate tax exemption has been historically high. As a result, very few estates are subject to federal estate tax, and thus fewer individuals need life insurance to compensate for the costs of federal estate taxes.
But life insurance also satisfies other wealth replacement needs. For example, many of the most significant assets people have are tax-qualified retirement plans (such as IRAs, 401(k)s, and pension plans). Because these are a special class of assets, they are subject to ordinary income tax when distributed to beneficiaries. Given the statistics that beneficiaries often deplete these assets quickly, they will incur significant income tax in withdrawing these assets. Therefore, a $1 million IRA may be worth substantially less after federal income tax, and even less after state income tax, too. Realizing this, many of us can benefit from life insurance designed to replace this lost wealth, thereby enabling our families to receive the full value of our assets.
Life insurance also serves the following wealth replacement needs:
- funeral and other last expenses
- estate administration expenses, including medical bills, the decedent’s debts, final individual income taxes, fiduciary income taxes, fiduciary commissions, attorney's fees, accountant’s fees, appraiser’s fees, and probate costs
Wealth Creation
A third basic need for life insurance is the creation of wealth. An individual may wish to add to his or her wealth at death for future generations or to fund personal philanthropic objectives.
Other Uses for Life Insurance
Many individuals use life insurance as a funding mechanism in other situations such as the following:
- buy-sell planning for business owners
- key employee coverage
- nonqualified deferred compensation
- liquidity for state death taxes
- inheritance equalization (for example, where only one child works in the family business that will be transferred to the child through lifetime gifts or upon the death of a parent)
Planning Tip: Life insurance is often the only vehicle that ensures that you will have the necessary liquidity when needed.
Irrevocable Life Insurance Trusts
Life insurance proceeds are not subject to income tax for beneficiaries who receive the payout. However, if the insured owns the insurance policy, these proceeds will be included in the insured’s gross estate and thus could be subject to federal and/or state estate tax. One simple way to avoid this result is to use a properly drafted and maintained irrevocable life insurance trust (ILIT). An ILIT that owns the life insurance can avoid federal and state estate tax on the life insurance proceeds. Such a trust can also ensure that the life insurance proceeds are available as you intended.
Planning Tip: Use an ILIT to ensure the value of life insurance is not included in your estate. This planning strategy will ensure that the life insurance proceeds are not subject to estate tax.
Conclusion
Life insurance is a unique asset that can provide the highest degree of flexibility for changes in the law or changes in your circumstances. Be sure to speak to your planning team and/or financial advisor regarding your life insurance needs.