Life insurance should be included in your financial plan

Term life policy types compared

Comparing types of cash-value life insurance

Comparing selected specialized/hybrid policies

Understanding policy provisions enables you to choose wisely

In order to purchase the most appropriate life insurance for your situation, you'll need a basic understanding of the terms and provisions commonly found in most policies. While some are boilerplate that you have to accept if you want the policy, others provide you with the opportunity to customize your coverage and/or reduce your premiums.

Receiving accelerated death benefits

Life insurance policies may include a provision that permits the accelerated payment of benefits to a policy holder who suffers from a serious medical condition (such as cancer, heart or kidney failure, AIDS, etc.) that will likely lead to his or her death within a specified time period, such as 12 or 24 months. Because the amount advanced comes from the "pure" term portion of the policy, both term and cash value policies may be written with an accelerated death benefit provision.

When acceleration is available under a policy, the amount that may be advanced under an accelerated benefit provision typically would be limited to a specified percentage of the death benefit (such as 50 percent of the death benefit) or a specific dollar amount (such as a $250,000 maximum benefit acceleration). If such an option is exercised, amounts paid during the insured's lifetime are treated similarly to a policy loan; interest accrues on the amount advanced, and the policy holder still owns the policy and must continue to pay premiums.

Viatical settlements

Viatical settlements should not be confused with the accelerated payment of death benefits by an insurance company to its insured. A viatical settlement occurs when a policy holder suffering from a terminal or chronic medical condition sells the insurance policy (at a discount from face value) to a third-party viatical settlement company, which is in the business of buying policies under such conditions.

Tip

If you are contemplating a viatical settlement, check with your state department of insurance to confirm that a viatical settlement company is licensed to do business.

When a viatical settlement is transacted, the policy holder typically retains no further interest in the policy and is relieved of the need to pay future premiums. The viatical settlement company takes ownership of the policy and responsibility for paying any future premiums, and it will receive the payment of benefits from the insurance company upon the death of the insured.

Considering life settlements

A life settlement, like a viatical settlement, is the sale of a life insurance policy by the policy holder (the insured) for less than the face value of the policy to a third party investor. As in a viatical settlement, the investor takes ownership of the policy and responsibility for paying any related future premiums, and makes its return on investment when it receives the death benefits under the policy upon the death of the insured.

The major difference between the life settlement and the viatical settlement is that the insured who is selling his or her insurance policy in a life settlement is not terminally or chronically ill. As a result, the investor is taking a greater risk that the insured will live longer,a factor that will be reflected in the pricing of the life settlement. Life settlements are typically designed for individuals who are over age 65 for whom the original reason for which the policy was purchased no longer exists. There are many companies that specialize in life settlement investments.

Tax consequences of accelerated death benefits or viatical settlements

If a person who is terminally or chronically ill receives accelerated death benefits or acquires the proceeds of a viatical settlement, the amounts received are treated as amounts paid by reason of the death of the insured. This means that the amounts received are not taxable income. The rationale for the exclusion is to ease the financial pressure on a person urgently needing cash to address a serious health care crisis.

• Terminal illness. A person is considered terminally ill if a doctor certifies that he or she has an illness or physical condition that can reasonably be expected to result in death within 24 months from the date of certification.
• Chronic illness. Chronic illness can include mental illness as well as physical illness or functional disability. A person is chronically ill if, within the previous 12 months, a doctor certified that he or she:
  • cannot perform, without substantial assistance, at least two of the activities of daily living (eating, toileting, transferring, bathing, dressing and continence) for at least 90 days due to a loss of functional capacity
  • has a similar level of disability as determined by the IRS in conjunction with the Department of Health and Human Services or
  • requires substantial supervision to protect himself from threats to health and safety due to severe mental problems.

If the benefits are paid to a chronically ill person for long-term care, any benefit amount in excess of the IRS per diem limit (various depending upon age) and the actual costs of such long-term care is not eligible for exclusion from taxable income. This limitation does not apply for the terminally ill person.

Tax consequences of accelerated death benefits or viatical settlements

If a person is not terminally or chronically ill at the time of the transaction, then the exclusion from taxable income does not apply. The proceeds of life settlements will be taxed, either as ordinary income or capital gain income.

Similarly, if a person who is not terminally or chronically ill surrenders his or her life insurance policy to the insurance company for its cash value, a portion of the proceeds from that transaction will be taxed as ordinary income.

Common insurance terms defined

To help you wade through the jungle of insurance terms, we've highlight the most important ones in A-E.

Beneficiaries: Receive policy proceeds

Probably the most important right that a policyholder has under a life insurance policy is to name a policy beneficiary; that is, the person(s) or organization(s) that will get the proceeds when the policyholder dies. Normally, the policyholder may change a beneficiary designation at any time, unless he or she has made the selection irrevocable.

When making a beneficiary designation, make sure that you follow the insurance company's rules to the letter. If you don't, the designation may be invalid. If you die without choosing a beneficiary, the proceeds will be paid to your estate. This will unnecessarily subject the proceeds to probate, and, particularly in those states that still levy an estate tax, is normally not an arrangement that you would want.

Cash value and loans: Put your premiums to work now

The cash value of a life insurance policy represents the investment component of a cash value policy (such as a whole life policy). The policy will state whether it has, or will have, any cash value. (If it will not, the policy is a term insurance policy.) The cash value should increase each year as you make premium payments, part of which are invested and earn income over time.

Upon the death of the policyholder, most cash value insurance policies provide that the amount of the cash value becomes a part of the total death benefit, rather than being an addition to it. Thus, if at the death of policyholder, a $100,000 policy has a cash value of $25,000, the policy beneficiary will receive $100,000, not $125,000.

Insurance loans

Cash-value life insurance policies allow the policyholder to borrow up to a specified percent of the cash value, frequently 95 percent, at fixed, or variable, rates. These loan rates are often less than those charged by commercial lenders, and can be received without the usual credit checks associated with commercial loans because the policy itself provides the security for the loan.

Paid-up insurance

Cash-value life insurance policies will also have a table showing the amount of paid-up permanent insurance that the policyholder can obtain on surrendering the policy, instead of getting cash or extended term coverage.

Dividends and dividend options: Pay you currently

Among life insurance policies, only participating policies pay dividends. Although they are called "dividends," the payments are not like dividends paid on stock. Instead, they are merely the nontaxable return of some excess premium by the insurance company based on lower-than-expected mortality expenses (fewer claims than expected) and administrative expenses, and/or higher than expected investment yields.

A participating policy will normally describe the five alternatives that can be selected with respect to any dividends that might become available:

1. Cash payment to the policyholder
2. Application to reduce premiums
3. Accumulation by the insurance company for the policyholder's benefit
4. Application to purchase paid-up insurance
5. Application to purchase one-year term coverage

Double indemnity: Pays more for accidental death

A double indemnity provision is a life insurance policy rider available for an additional premium under which the beneficiaries are paid double the face amount of the policy if the insured dies as a result of an accident, rather than from illness or natural causes. The cost of this rider may range from 75 cents to $1.00 in added annual premium costs for each $1,000 in coverage.

Because of the tenuous relationship between how one dies and what one's beneficiaries' needs are, it is usually advisable to forgo purchasing double indemnity coverage. If you need more insurance, it's normally a better idea to use what you would have paid for the double indemnity rider to buy more coverage, rather than to "bet" that you will oblige your beneficiaries by dying in an accident, rather than by illness.

Extended insurance, premium waivers: Forgive late premium payments

Cash value life insurance, but not term insurance, provides that if a premium is not paid within the specified time limit, the coverage may not be terminated. Instead, the premiums are "paid" from the accumulated cash value of the policy. Therefore, the insurance generally continues as term insurance for a limited period, which can sometimes run for several years, depending on the amount of the policy's accumulated cash value.

The waiver of a premium rider provides that the insurance company will not collect premiums for a period of time during which the insured is disabled. When you are comparing the prices of policies issued by different insurance companies, keep this in mind: With some policies the rider is automatic, the cost being built into the annual premium. 

With others, it's an optional feature, the cost of which may vary depending on age, sex, the terms of the waiver and the particular insurance company. Although most insurance agents seem to swear by the waiver of premium coverage, if you must pay extra for it, ask yourself if you have adequate disability income coverage. If you do, maybe the waiver of premium coverage is something that can safely be passed up.

Guaranteed insurability: Prevents loss of insurance

A guaranteed insurability rider gives the life insurance policyholder the right to purchase specified amounts of additional insurance at specified times. It is generally available only if the insured is under 40 years of age, and is less readily available with term policies. The cost of this rider varies, but often is approximately $1.50 per $1,000 of additional coverage. The premium for the added coverage is based on the insured's age at the time the added coverage is acquired.

Ownership and assignment clauses: Prescribe how to transfer policies

The person who owns the life insurance policy (the policyholder) is named in the ownership clause. The policyholder is usually the same person who is insured under the policy, but this does not have to be the case.

An insurance policy will also specify the rules for assigning (transferring) the policy to a new owner. Usually, the insurance company is not bound by the assignment until it receives a written notice of assignment. The assignment is subject to any outstanding policy loans. If used wisely, assignments of life insurance policies can be one of the best ways to make tax-free transfers of wealth to family members and others.

Participating policies: Pay dividends

Participating policies are issued by mutual life insurance companies; that is, insurance companies owned by their policyholders, rather than by stockholders. Unlike nonparticipating policies, participating policies pay dividends. In contrast, nonparticipating policies are life insurance policies issued by insurance companies that are owned by stockholders rather than policyholders. Nonparticipating policies do not pay dividends. Because of this, such policies normally have lower premiums, although, in the long run, participating policies may prove less costly.

Riders: Cover special situations

A policy rider is a provision that is added to the basic coverage of an insurance policy, by agreement of the policyholder and the insurance company, often for additional cost. The double indemnity and the waiver of premium provisions are common policy riders.

Settlement options: Determine how proceeds are paid

At the death of the insured, unless another arrangement has been made, the insurance proceeds will be paid to the beneficiary in a lump sum.

However, life insurance policies usually give the policyholder (or the beneficiary) the right to choose non-lump sum payouts, known as settlement options. There are five common types of settlement options:

• Interest only. The beneficiary receives interest on the proceeds held by the insurance company. The policyholder may provide for someone (known as a contingent beneficiary) to take the proceeds at the first beneficiary's death. Or the initial beneficiary may be given the right to withdraw some or all of the proceeds in a lump sum from the insurance company.
• Fixed period payments. The beneficiary will periodically receive as much money as the proceeds will "buy" for a specific time period. For example, the beneficiary might receive a specified amount each month for 20 years.
• Fixed amount payments. The beneficiary will periodically receive a specified amount until the proceeds are exhausted.
• Life income (annuity). The beneficiary will periodically receive a certain monthly payment for his or her lifetime. The amount of this payment will be determined by the amount of the proceeds and the life expectancy of the beneficiary at the time of the insured's death.
• Joint and survivor life income (annuity). The beneficiary will periodically receive a payment for life. Thereafter, his or her spouse receives periodic payments for life. Under this option, the amount that the surviving spouse will receive is sometimes reduced to one-half or two-thirds of the amount that first beneficiary's received.

Tip

Although insurance companies have touted settlement options as "a poor man's trust," the insurance agents we have talked to are almost unanimous in this advice: "take the cash." The unstated assumption here is that in computing amounts to be received under settlement options, the insurance companies use interest rate assumptions that aren't particularly favorable to beneficiaries.

Using life insurance to replace your business income

You may have noticed the overwhelming majority of our life insurance advice focused on your personal financial situation. Although life insurance is usually used for personal needs, your business situation may affect your need for life insurance.

What if your family can't take over your business?

You should ask yourself whether your spouse, family or dependents will be economically damaged if you are not there to run the business. Unless one or more of these people can step in to run the business at your death, you should think about whether the income from your business needs to be replaced.

For example, if your business is a family diner, you can start teaching your family the ropes early on. However, if you're an independent marketing consultant, your knowledge can't be easily transferred.

Factor in all other insurance that you have on your life and whether your family's expenses will go down if you are no longer there.

Example

John Stead's business (writing handicapping information for horse racing publications) generates yearly profits of $45,000, the only source of his family's income. Because no one in his family has the specialized skills to run the business, he does not intend that it will be operated after his death, and the business has no value after his death.

He figures that if he is not alive, his family expenses will be decreased by $10,000 per year. He will need to replace $35,000 of yearly income.

Once you know the amount of income that needs to be replaced, you need to estimate how much investment return your survivors can obtain on the insurance funds. For example, if your heirs must replace $20,000 of income and can make 5 percent on their money, they will need $400,000 from insurance or other sources to do this.

What if your survivors run the business?

If you plan that your surviving spouse, family or others will continue to operate your business after your death, the question then becomes whether they can pick up where you left off without a period of lessened profits.

Level profits

The best situation is where there will be no let-up in profits after your death. To achieve this, you must have operated your business in such a way that your family members know what must be done, and can do it. If you are at this point, you have probably involved your family in all aspects of business operation already. 

For example, they will be experienced in dealing with customers and suppliers, if that is required by your business. If this is the case, you have no particular increased need for life insurance because of your business, unless you wish to use it to meet certain lifetime needs. However, you may wish to purchase life insurance to provide a ready fund to pay any estate taxes that will be due, so that your heirs don't have to sell off needed business assets to pay Uncle Sam.

Diminishing profits

It certainly would not be unusual if the family members who continue to run your business could not do so as profitably as you could—at least, not right away. No matter how talented or industrious they are, if they have not been intimately involved in the day-to-day running of the business, they probably will not be able to do everything as well as you did. This is particularly true with businesses that require specialized business knowledge or training, and businesses that depend on long-standing personal relationships with clients, customers or suppliers.

If you think that it will take your family members or heirs a few months, or a few years, to get the business back to where it's making the same profits that it did for you, life insurance can be used to bridge the period of diminished profits.

Example

Philip Labrador operates an up-scale dog grooming salon. He has established a reputation with wealthy dog-show exhibitors as the best groomer in the area, and his business earns profits of $70,000 per year.

His son, Chuck, is an accomplished groomer himself, but does not have his father's business savvy or reputation with clients. Philip believes that if he died tomorrow, Chuck probably could operate the business at a profit of only $35,000 a year. With diligent effort, however, Chuck could have the business back to earning yearly profits of $70,000 in three years.

Assuming that Philip wants Chuck to have the benefit of the full $70,000 income for the three years until Chuck can get the business back to its previous level of profits, Philip will need to make up for a $105,000 shortfall. This could be done by an insurance policy on Philip's life sufficient to pay a death benefit of $105,000, spread out over the three-year "bridge" period.

Lower profits

You may conclude that your family will be able to run the business profitably after your death, but never at the profit level that you did. If this is so, and you want to provide your survivors with the same level of income that they enjoyed during your life, you will have to do something to make up for this shortfall in income.

Example

Mary Green works 80 hours a week operating a landscaping business. Her yearly income from the business is $40,000. She believes that her husband, Gary, could run the business after her death, but because he has another job, could only devote to it enough time to make a yearly profit of $20,000. 

If Mary wants Gary to enjoy the benefit of his salary plus the $40,000 per year that had come from the landscaping business during her life, she will need money from insurance (or other sources) sufficient to earn $20,000.

In the example above, insurance could be used to make up for the shortfall.