Understanding life insurance

Many people have questions about life insurance. There is no one answer to determine how much life insurance to have, but understanding your reasons for holding it can help guide you.

Types of insurance

In general, there are two types of life insurance: term insurance and permanent insurance. (There are also products that combine other types of insurance, such as long-term care, with life insurance; we’re just going to talk about pure life insurance in this WealthFocus.)

Term insurance insures you for a fixed term, in some cases even just for one year. The premium, or cost of insurance, generally increases each year, since you’re another year older and statistically more likely to die during that year of coverage. There are also products that allow you to lock in a premium for a number of years. These cost more in the initial years than a one-year term policy, but the premium is guaranteed not to increase for a specified number of years. If the person whose life is insured outlives the term of years, the policy either expires or the premium is subject to a significant increase. Sometimes term policies can be converted into permanent insurance.

Unlike term insurance, permanent insurance remains in place for the insured’s lifetime. Permanent insurance includes both a term component and a savings or investment component. Premiums are higher for permanent insurance than they are for term insurance, but the savings component can earn a return that may add to the “cash value” of the policy. For certain policies, this return can be used to pay the cost of insurance, reducing or even eliminating the premiums that you have to pay over the years.

There are two primary reasons for individuals to purchase life insurance:

Income replacement

A primary purpose of life insurance is to try to help ensure that your surviving loved ones, most frequently a spouse and children, have their needs met when you are no longer earning income or taking care of the day-to-day tasks around the house. In either case, your role will have to be replicated, and the question of how much life insurance you need depends on how much money will be required to replicate your role as a provider. Will your family have to generate a certain amount of money in interest and dividends to replace your salary? Will they need to have enough money to hire babysitters, drivers, and other people to replace the roles that you filled?

For income replacement, especially if you’re worried about dying prematurely, a term policy with a level premium can be a good option. Do you have a particular expense that you want to make sure is paid? College for your children? Paying off your mortgage? Ensuring that your spouse has a certain amount of annual income? Making some assumptions about rates of return, you can come up with a number that will achieve your goals.

Providing liquidity and replacing estate taxes paid

Life insurance can also be helpful for replacing estate taxes paid or for providing liquidity for families with an illiquid but taxable estate. An illiquid estate means an estate with assets that cannot quickly be sold and turned into cash at a reasonable price. (Keep in mind, if you live in a state that has its own independent estate tax, you may have a taxable estate for state purposes even if you are under the federal threshold.) If this is the case, insurance won’t reduce the amount of tax that might be owed, but it can provide immediate cash to pay the tax. This tax must be paid within nine months of death to avoid interest and penalties.

There are a number of other reasons that people purchase life insurance (e.g., to fund a buy/sell agreement, to insure a key employee, to fund ongoing financial obligations after death, etc.), but these are beyond the scope of this article.

Can I use my will to change the beneficiary of my life insurance policy?

No. The beneficiary designation for your life insurance policy controls who receives the insurance proceeds. You cannot change your beneficiary by naming someone different in your will or in a trust. Instead, you must change the designation form provided by your insurance carrier or broker in order to change your beneficiary. This is especially important when life changes occur, such as if the named beneficiary passes away or you divorce from the named beneficiary.

Who should own a life insurance policy?

Insurance proceeds are not taxable as income. However, if you own a policy on your own life, your estate may have to pay estate taxes on the proceeds. Even if you leave the proceeds to your spouse (in which case there would be no estate tax because your estate would be entitled to the marital deduction), if your spouse has a taxable estate when he or she dies, the excess over the exemption (federal or state) will be subject to estate tax.

Creating an irrevocable life insurance trust, sometimes called an ILIT, to own the policy and to be named as the beneficiary can significantly increase the likelihood that all of the insurance proceeds will be available for your family when you die and that none of it will be subject to estate tax. Depending on the terms of the ILIT, insurance proceeds in an ILIT may also be protected from claims by creditors of the ILIT’s beneficiaries.

If the ILIT is the initial owner of the policy, proceeds should be excluded from estate tax at both your death and your spouse’s death. If you transfer an existing policy to an ILIT, you have to live for three years after the transfer in order for the policy proceeds to be excluded from your taxable estate.  It’s important to remember that if an ILIT owns a life insurance policy on your life, your spouse and children can, and often should, be beneficiaries of the ILIT so they can have access to the insurance proceeds.

Talk to a J.P. Morgan advisor to help you think through some of these issues, and to review your beneficiary designations.

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