“Why Do I Need Life Insurance?”

The various business and personal uses for life insurance

I get posed this question often- “Why do I need to purchase life insurance?” People of all backgrounds, ages and economic situations seem to not fully understand the versatile uses of a life insurance policy and the economic benefit that it creates. Here are just some of the many reasons that everyone should consider purchasing life insurance coverage for personal or business purposes:

Preservation of Family’s Economic Security

A family’s way of life and lifestyle lies in the earning ability of each income producer in the household. If a breadwinner dies before reaching retirement the unrealized portion of his or her earnings potential will be lost, and the family will soon find itself reduced to a lower income than it previously enjoyed.

By means of life insurance, an individual can assure that his or her family will receive the monetary value of their income-producing qualities, regardless of when death occurs. Life insurance can be tailor-fit for each individuals specific needs and wants.

Death benefits can be received in many ways and allow the beneficiary or the insured to structure the payments however they would like. Subject to some exceptions, most death benefit proceeds paid under a life insurance contract are excludible from gross income for federal income tax purposes.

Preserve Insurability & Cost

Why would someone ever purchase life insurance for a child? The most common reason grandparents and parents purchase life insurance for their children is to preserve insurability in the event their child contracts a serious illness or injury that may affect their ability to purchase life insurance in the future. Whole life insurance is typically used for anyone under the age of 18 and allows them to increase their coverage at a certain age without any further medical underwriting. These policies also, build cash value. Life insurance policies for children are very inexpensive and a great gift that a child can learn to appreciate.

What are the advantages of purchasing it at a young age? Purchasing life insurance at a young age has many advantages. The most visible being the premium. Life insurance carriers use life expectancy tables when computing premiums. As you grow older your life expectancy decreases, which in turn increases the premium. Many other factors determine the rate that you pay like; tobacco use, body mass index, hereditary illnesses and so on, but age is the single most determining factor. Rule of thumb: life insurance premiums increase on average of 9% each year that you grow older.

Business Uses

Life insurance is used everyday in business related transactions and sometimes is required by a lender before a line of credit can be established. The flexibility and versatility of the policy make it a very cost efficient tool. Not to mention the advantages of tax free proceeds. Here are a few ways how a life insurance policy can help protect your business financially and add value to your bottom line:

Key Person IndemnificationIts purpose is to pay a business from lost earnings caused by the death of a key officer or employee. In many businesses there is one person whose capital, technical knowledge, experience, or business connections make him or her the most valuable asset of the organization and a necessity to its successful operation.

A key person insurance policy can be purchased for a temporary period of time or for a more permanent solution, cash value life insurance is used. The cash value accumulation is reflected as a liquid asset on the business’s books.

Credit Enhancement– Life insurance can enhance a business’s credit in two general ways: by improving its general credit rating and by making collateral available.

Anything that stabilizes a business’s financial position improves its credit rating. Insuring the lives of key personnel assures lending institutions that the business will have a financial cushion if a key person dies. It also improves the firm’s liquidity through the accumulation of cash values that are available at all times. As a result, the firm is able to attain a higher line of credit and/or better terms. Not too mention loans of smaller values will no longer be needed by an outside bank if cash value funds are available for use.

Business ContinuationBuy-Sell agreements are used everyday when a new business is formed with multiple owners. These agreements stipulate the method of valuing each owners interest and allows the remaining owners to purchase the shares of a deceased partner.

Life insurance is uniquely suited to financing such agreements since the very event that creates the need for cash also provides the cash. Structure of these agreements depends on the size of the ownership group, but “cross-purchase” is typically utilized. Owner’s can choose either temporary coverage or a permanent product with cash value accumulation.

Not only is life insurance the most cost-effective & efficient tool available for purchasing shares of a business because of the ability to buy “discounted dollars”, but the cash value can be utilized as the down payment for the business while still having the death benefit available.

The flexibility of a permanent life insurance policy allows a business successor to purchase the business for much less than attaining a traditional loan from a lending institution. The business can fund the premiums through a payroll structure, which increases the businesses write-offs virtually costing them nothing. Or own the policy itself and transfer it as a “bonus” and receive a tax deduction. The difference is night and day when compared to other financing tools.

Retirement Needs & Emergency Fund

Having a permanent life insurance policy as part of your retirement portfolio is key to having a well balanced and secure retirement plan. At the very least it provides a security blanket for your spouse and/or children in the event that you die before reaching retirement age.

There are only so many tax free retirement buckets that allow tax-free growth along with tax-free withdrawals. Most have limitations and restrictions on who can invest in those vehicles, the amount that can be invested, or the use of the withdrawals. Except, for ordinary life insurance.

Here is a break down on the function of each permanent life insurance product and how each are treated for federal tax purposes:

Whole Life

  • Death benefit is level and coverage is permanent for the entirety of the insureds life span.
  • Premiums remain level and do not fluctuate.
  • Tax free cash value accumulation that is liquid and can be withdrawn without incurring a penalty. Any withdrawals above your basis are viewed as “loans” and are free from income taxation.
  • Dividend payments are available for participating policies.
  • All death benefit proceeds received by the beneficiary(s) are tax free.

Universal Life

  • Option to choose either a level death benefit or an increasing death benefit that will pay the death benefit along with the cash value balance.
  • Premiums can be flexible throughout the life of the policy and are only required in the first year.
  • Tax deferred cash value growth.
  • Partial withdrawals from the policy’s cash value without incurring any indebtedness or interest and without any obligation to repay those funds.
  • Tax free policy loans are available, but may be subject to fee’s.
  • Death benefit proceeds received by the beneficiary(s) are tax free.

Index Universal Life

These policies have all of the normal features of a regular universal life insurance policy like; flexible premiums, level or increasing death benefit, tax free death benefits, and so on. The difference is the ability for consumers to invest into stock indexes without the risk of directly investing into the stock market. Here are some of the unique features of an index universal life policy:

  • Premiums are lower than traditional universal life insurance, but also, carry more risk.
  • Tax deferred cash value growth is tied to specific stock indexes such as the Standard & Poor’s 500 and participates in favorable investment returns (subject to caps).
  • Minimum interest crediting rate applied to cash value each year no matter how investments perform.
  • Policyholders are allowed to participate in the selection of indexes and have some control over investment allocation.

Variable Life

A variable life insurance policy provides no guarantees of either credited interest rate or minimum cash value. Policyholders bear 100% of the investable risk and, therefore, can participate in favorable investment returns. These policies should be viewed as longterm investments. Here are additional features of a variable life insurance policy:

  • Premiums are guaranteed and will never increase.
  • Minimum death benefit is guaranteed as long as the minimum premium payment is made.
  • Increasing death benefit is possible dependent on the investment performance.
  • Policyholder’s have complete control of the investment allocation and fund selection and can make changes at anytime.
  • Tax deferred cash value accumulation.
  • Policy loans are available, but may be subject to fee’s.
  • Death benefit proceeds received by the beneficiary(s) are free from income taxation.

Variable Universal Life

Variable universal life insurance incorporates all of the flexibility and policy adjustment features of the universal life policy with policy owner-directed investment aspects of variable life insurance. Although, very similar to a variable life contact, here are the unique features of a variable universal life policy:

  • Premiums can be flexible throughout the life of the policy.
  • Flexible death benefit that can be level or fluctuating depending on the needs of the insured.

Closing Remarks

As you can see having a permanent life insurance policy as part of your investment portfolio can offer many advantages as well as the security that other investments cannot offer. Its tax free aspects make it an efficient investment vehicle and its liquidity provides additional flexibility that can be used for healthcare costs, home improvement needs, low interest business loans, emergencies, retirement needs, etc.

Life insurance is a sure means of changing uncertainty into certainty and is the opposite of gambling. Someone who does not insure gambles with the greatest of all chances and, if they lose, makes those dearest to them pay the forfeit.

*Outstanding policy loans at the time the insured dies will reduce the death benefit by the amount of the loan plus any unpaid interest on the loan.

**Life insurance premiums are paid using after tax dollars and cannot be deducted for tax purposes since most proceeds will be received tax free.

Published by Michael A. Luna, CIC

Asset protection specialist helping families and business owners achieve their goals.

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