Chapter 11 Life Insurance

List the five most common objectives of using life insurance in an estate plan.

The five most common objectives of using life insurance in an estate plan are as follows: Protecting the income stream of the client's family. Providing liquidity at the insured's death. Providing a source of retirement income. Funding the children's education. Creating or sustaining family wealth.

Identify the parties to a life insurance policy.

The owner, the insured, and the beneficiary of the policy.

Why is the premium on a term insurance policy lower than the premium on a permanent policy?

The premium on a term insurance policy is lower than the premium on a permanent insurance policy because the term insurance policy has a level premium for a fixed term, which is a period in which it is less likely that the policyholder will prematurely die. The fixed term is shorter than the life term for permanent insurance. The premium on a term insurance policy reflects the actuarial risk that the insured will die during the term of the contract. Other types of permanent insurance include an amount within the premium that is allocated to a savings account.

How is the surrender value of a life insurance policy calculated?

The surrender value of a life insurance policy is the amount an owner will receive if he surrenders his life insur- ance policy to the insurance company. The surrender value is the cash value of the contract less a surrender charge.

What is the advantage of paying off debt at the death of the first spouse?

The surviving spouse will not have the burden of servicing an outstanding debt. Without this burden, monthly expenditure requirements are lessened, and if the surviving spouse is not skilled at managing his finances, paying off debt provides some protection against future financial problems.

With regards to the federal estate tax and life insurance, what is the three-year rule?

The three-year rule states that if an individual gratuitously transfers ownership of a life insurance policy on his or her life, or any incident of ownership in a policy on his or her life within three years of death, the death benefit of the policy is included in the individual's gross estate.

Define "incident of ownership" in a life insurance policy and give an example.

An incident of ownership in a life insurance policy is the ability to exercise any economic right in the policy. The right to borrow from the cash value of the policy, the right to assign the policy for a loan, and the right to change the beneficiary of the policy are all incidents of ownership in a life insurance policy.

The designated beneficiary of a life insurance policy will receive the death benefit of the policy at the death of the insured. Why is the designation of the beneficiary not a completed gift for federal gift tax purposes?

The designation of the beneficiary of a life insurance policy is not a completed gift for federal gift tax purposes because the owner may still exercise all economic rights over the policy, including the ability to change the des- ignated beneficiary again.

What guarantee does the insurer give the insured under a whole life insurance policy?

The insurer guarantees that the life insurance policy will remain in force as long as the insured pays a stated premium each year.

In general, how is the value of a paid-up life insurance policy determined for federal gift tax purposes?

The value for federal gift tax purposes of a paid-up life insurance policy is the replacement cost of the life insurance policy as of the date of the gift.

How is a term insurance policy used when an estate plan includes a GRAT?

If the grantor dies within the estate tax inclusion period of the GRAT, the fair market value of the assets within the GRAT will be included in the decedent's (grantor's) federal gross estate. The inclusion of the assets will cre- ate additional estate tax due (potentially equal to 45% of the fair market value of the assets), but the assets will physically transfer to the beneficiaries of the trust per the trust document. The assets do not revert to the grantor's estate. The grantor can purchase a term insurance policy with a term equal to the estate tax inclusion period, and a face value equal to the federal estate tax that would be created by the inclusion of the GRAT's assets at a lower premium cost than 45% of the fair market value of the GRAT's assets. So, if the grantor dies within the estate tax inclusion period, the term insurance policy will provide the cash necessary to pay the additional federal estate tax due.

In the event that a life insurance policy does not have a named beneficiary, who receives the death benefit?

In the event that a life insurance policy does not have a named beneficiary, the owner of the policy will receive the death benefit.

What provision allows the gift of premium payments to an ILIT to be eligible for the annual exclusion?

Including a Crummey provision in the trust document of an ILIT will make the gifts of premium payments to the trust eligible for the annual exclusion.

Discuss the tax consequences to a beneficiary who chooses to leave the life insurance proceeds on deposit at the insurer.

A beneficiary who chooses to leave the life insurance proceeds on deposit with the insurer will receive interest income that accrues on the balance of the proceeds. The interest income will vary depending upon the amount of the proceeds and the prevailing market interest rates. This interest income is taxable to the benefi- ciary, but the balance of the proceeds will remain nontaxable, provided the policy was not subject to the trans- fer for value rule.

Why is liquidity an issue for a large estate?

A large estate is often comprised of a few, or even one, large asset. Commonly, the asset is an interest in a closely held business whose appraised fair market value is much greater than any other asset, and whose large value is based upon future earnings and the value of the company's fixed assets. Consequently, the federal estate tax, and any corresponding state estate or inheritance tax, is calculated including this fair market value, even though the value cannot be used to pay the estate taxes due. (You cannot pay estate taxes with fixed assets or future earnings.) Within nine months of the decedent's death, his estate will be required to pay the estate taxes. To avoid having to quickly sell the company's assets, which may create income tax consequences, a life insurance policy can be used to fund the cash necessary to pay the estate taxes.

Define a term life insurance policy.

A term life insurance policy is a life insurance contract that states that if the insured dies within the term of the contract, the insurance company will pay a stated death benefit.

In general, how does a variable universal life insurance policy differ from a universal life insurance pol- icy?

A variable universal life insurance policy allows the insured to choose how the cash account is invested. The cash account of a universal life insurance policy is invested in the bond portfolios of the insurer

List some of the advantages and disadvantages of taking a loan from a life insurance policy.

Advantages: The interest rate may be lower than commercially available lending rates. The loan does not have to be paid back. Disadvantages: The outstanding loan balance, plus the accumulated interest, will reduce the death benefit on the policy dollar for dollar. If the policy lapses, the gain in the policy will include the outstanding loan balance and will be subject to income tax.

Why is liquidity an issue when a decedent's assets pass through the probate process?

Because a decedent's property may have to go through the probate process, it can take several months for the family to actually receive the property. During those months of waiting, the family will need cash to pay the mortgage, buy clothes for the children, pay private school tuition, and keep food on the table. The family may also need cash to pay the funeral expenses and last medical expenses of the decedent. An insurance company pays the beneficiary of a life insurance policy upon presentation of the death certificate. Although this process is not instantaneous, it is usually much quicker than the probate process and will provide the family with the necessary cash.

How can life insurance fund retirement needs while the insured is still alive?

If a cash-value policy is purchased, and the premium is paid on a regular basis, the policy cash value will grow over time. At retirement, if the insured's estate will not have liquidity needs, or need the life insurance pro- ceeds for other purposes (as discussed above), the insured can take tax-free distributions of basis and take loans from the cash value of the policy to supplement retirement income. All of this assumes that the insured is also the owner of the policy, a situation that is usually avoided in estate planning because it will cause the proceeds of the policy to be included in the insured owner's federal gross estate.

Briefly describe the transfer-for-value rule.

If a life insurance policy is transferred for valuable consideration, the death benefit in excess of the transferee's adjusted basis will be subject to income tax.

How can the owner of a life insurance policy receive a current income tax deduction for the value of the life insurance policy?

Life insurance is generally considered ordinary income property. Thus, the gifting of life insurance policies to a charity will follow the charitable rules for ordinary income property. The deduction for donated ordinary income property is equal to the fair market value of the property reduced by any ordinary income that would have resulted from its sale - usually the adjusted basis of the property. In the event the fair market value is less than the adjusted basis (no ordinary income would result from this sale), the deduction is equal to the fair market value of the property itself. If the policy is "paid-up" (i.e., no premiums remain to be paid), the fair market value is equal to the policy's replacement value. If premiums remain unpaid on the policy, the fair mar- ket value is the policy's interpolated terminal reserve value. If the donor continues to pay the premiums on any policy donated to a charity, those premium payments are an additional tax deductible charitable gift.

How is life insurance included in a plan for funding college education?

Many parents want to help their children by providing them with the funds necessary to attend college. Usu- ally, parents will develop a plan to contribute a certain amount, monthly or yearly, to an account or an Educa- tion IRA. The necessary contribution is calculated based on the number of years until the child begins attending college, and each contribution must be made to provide the child with the planned amount for college. If one parent dies before completing the funding, the contribution may become too much of a financial burden, or may be overlooked by the surviving parent. Life insurance can be used to provide the funds neces- sary to continue funding the contribution, or it can be used as a lump sum funding equal to the difference between the amount funded before the parent's death and the remaining amount necessary.

List the basic types of life insurance.

The basic types of life insurance are term insurance, universal life insurance, whole life insurance, and variable universal life insurance.

List the settlement options available for life insurance policies.

The beneficiary of a life insurance policy can choose among the following settlement options: Lump sum death benefit, Leave the life insurance proceeds on deposit with the insurer and receive interest income, or Annuity option.

How is the cash value of a whole life insurance policy invested?

The cash value of a whole life insurance policy is invested in the bond portfolios of the insurer.

List the exceptions to the transfer-for-value rule.

The transfer for value rule will not apply when there is a transfer of the policy to any of the following individ- uals: The insured, A partner of the insured, A partnership in which the insured is a partner, A corporation in which the insured is a shareholder or officer, or A transferee who takes the transferor's basis in the contract.

In general, how is the value of a life insurance policy in pay status determined for federal gift tax purposes?

The value for federal gift tax purposes of a life insurance policy in pay status is the sum of the policy's interpo- lated terminal reserve plus any unearned premium as of the date of the gift.

How does a universal life insurance policy differ from a term life insurance policy?

Unlike a term insurance policy, a universal life insurance policy has a cash accumulation account. The cash accumulation account grows tax-deferred and in any given year, the owner of the policy can decide to reduce his premium payment by the value of the cash accumulation account.

How can life insurance provide financial security for a surviving spouse in retirement?

Usually throughout an individual's life, he contributes to various savings mechanisms to provide income for himself and his spouse during his retirement. If an individual dies before his goal has been fully funded, a shortfall may result for the surviving spouse. Life insurance can provide a lump sum at a decedent's death that will provide needed retirement income for the surviving spouse.

How do dividends from corporations differ from dividends on a life insurance policy?

When a corporation distributes a cash dividend to its shareholders, the dividend represents a distribution of the earnings and profits of the corporation, which is fully subject to income tax. A dividend on a life insurance policy is a return of the premiums paid to the policy owner which constitutes an overcharge by insurance com- pany. The return of the overcharge is not taxable to the extent that the policy owner has an adjusted basis in the life insurance policy.

Why is the strategy of "buy term and invest the difference" not an optimal strategy for people who have a permanent need for life insurance protection?

When an individual has a permanent need for life insurance protection, buying term and investing the differ- ence can be a disaster. As the individual gets older, the premium of the term policy will rise exponentially. At advanced ages, the annual cost of the insurance policy may be prohibitive, and if the premium is not paid, the insurance will lapse.

When selecting the amount of life insurance needed to protect the income stream of beneficiaries, what should be considered?

When selecting the amount of life insurance needed to protect the income stream of beneficiaries, the follow- ing should be considered: The annual income needed by the family. The family's outstanding debt. The need to replace the income of the decedent. Any extra expenses that a surviving spouse may incur since the decedent's domestic services will no longer be available to the family.

If an owner elects to receive the surrender value of the life insurance policy, why might it be taxable?

When the owner elects to receive the surrender value of the life insurance policy, the policy benefit is not being paid out by reason of the death of the insured, and therefore does not qualify for the income tax exclusion (under IRC Section 101(a)). If the surrender value paid to the owner is greater than his adjusted basis in the policy, the difference between the amount received and the owner's adjusted basis is considered taxable ordi- nary income.

If the owner of a life insurance policy gifts ownership of the policy to charity, what is the effect of the owner continuing to pay the premiums?

When the owner gifts ownership of the life insurance policy to a charity and continues making the premium payments, the owner will have an itemized deduction equal to the premium payment.