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AAII Journal - November 1995 Important life insurance planning issues include: The amount and type needed, possible policy replacement, the versatility of universal life and estate planning possibilities. The Life Cycle of Insurance Needs: A 30-Something Example By Peter Katt Most investors are familiar with the concept of the investment life cycle - changing investment strategies over one’s lifetime. Life insurance needs follow a similar pattern - as one moves through the various economic stages, life insurance needs change. How do they change over time? To illustrate the concept, this article features a "thirtysomething" professional who is updating his life insurance program. Meet Dr. Jeff Tower, a thoracic surgeon. Jeff is 38, married, with two healthy young children (ages four and six). Chris, Jeff’s wife, doesn’t currently work outside the home. Jeff earns $240,000 annually. The Towers have accumulated investable assets of $300,000, including Jeff’s pension plan. Life Insurance Needs In as much as Jeff is the primary family income earner, his life insurance need is to protect his family in the event of his death. While there are many ways to calculate how much life insurance is needed for family protection, the method I prefer calculates the amount of principal needed to provide Chris and their children with a monthly income that Jeff and Chris believe is appropriate. Jeff and Chris determine that she and the kids could do fine with $12,000 a month, pretax, or $144,000 annually. Jeff believes that 7% is a prudent investment yield assumption, so by dividing 0.07 into the annual survivor’s income goal we can compute the approximate amount of principal needed (about $2.0 million) to produce an annual income of $144,000, if the invested principal earns 7%. From this $2.0 million figure we subtract current investable assets and existing life insurance. In the Towers case, they have $300,000 of investable assets, $15,000 of permanent insurance on Jeff’s life and a $500,000 10-year level term policy purchased two years ago. Therefore, we tentatively conclude that new life insurance of about $1.185 million is needed to satisfy Jeff’s survivor’s income goal of providing his family with annual income of $144,000 in the event of his death. (We haven’t calculated specific financial needs, such as education funding for the kids, or factored in inflation. We also didn’t take into account possible offsetting factors such as Chris going back to work as a nurse practitioner, or her remarriage. Being able to precisely calculate the correct amount of life insurance for survivors’ protection, taking into account all possible factors, isn’t necessary.) Jeff and Chris also decide there is no risk management reason to insure Chris or their children. Since most families have a limited budget, it should be allocated to cover the greatest risk, which in this case is the premature death of Jeff, the family income earner. Another consideration is the possibility of coming into money in the future. Chris is likely to inherit $500,000, or more, from her parents who have just entered retirement in great health. Jeff and Chris could reduce the amount of insurance on Jeff’s life for family protection in anticipation of Chris’ inheritance. However, they decide not to depend on this inheritance since it probably won’t happen for many years. Chris’ potential inheritance, however, is an issue that will be revisited in the future as the Towers accumulate their own wealth. It may make sense, say in 10 years, to discuss with Chris’ parents the possibility of diverting some or all of her inheritance to a generation-skipping trust. Chris could have the right to income from the trust and principal based on a predetermined standard. This could provide the Towers with some income tax planning options (the generation-skipping trust could provide education funds for the children, with the kids declaring the income, presumably with a lower marginal income tax rate) and reduce Jeff and Chris’ eventual estate taxes. Combining Term and Cash Value After reviewing various options for the purchase of new insurance on Jeff’s life, the Towers decide to purchase a 15-year level term policy for $935,000 and a $250,000 cash value policy for the balance. The 15-year level term policy for $935,000 coordinates well with the existing $500,000 10-year level term policy (with eight years to run), because the goal is for Jeff and Chris’ invested assets to replace most of the need for life insurance over time. And, the need for a large amount of insurance on Jeff’s life will dissipate as their children grow up. The 15-year level term policy for $935,000 has an annual premium of $1,500. The $250,000 cash value policy will serve the dual functions of providing the additional family protection desired and to accumulate significant cash values. This dual function is possible when a universal or variable life policy is superfunded to take advantage of its investment possibilities. That is, the projected annual premiums will be the maximum allowed without the policy being considered a modified endowment contract (MEC)(MEC policies’ cash value withdrawals and loans are taxed in a less attractive way than non-MEC policies, therefore avoiding MEC classification is required in this case). By superfunding the cash value policy, the Towers can take maximum advantage of the tax benefits of cash value life insurance, which are: tax-deferred build-up of the cash values; income-tax-free withdrawals of cash values (up to cumulative premiums paid); and death benefits that are income-tax-free. The superfunded cash value policy can be used as an adjunct to educational funding, additional income in retirement, or as an inter-generational wealth transfer asset by eventually transferring it to an irrevocable trust. After evaluating the realistic difference between universal and variable universal life, Jeff decides to purchase his superfunded cash value policy as universal life. (See my January 1994 AAII Journal column for a comparison of variable and universal life). Policy Replacements A review of the two whole life policies, purchased many years ago by Jeff’s father, with combined death benefits of about $15,000, discloses that while purchased from a great company, they are very expensive because the fixed costs of such small policies overwhelm the unit costs. In this case, the unit costs appear to be about 25% higher compared with incorporating the $15,000 whole life policies of permanent coverage into the superfunded universal life policy, which will now have an initial death benefit of $265,000. Two points need to be made about policy replacements. First, there is far too much of it because of the inherent conflict of interests associated with a commission-only compensation system for insurance salesmen. However, there are rational reasons to consider the replacement of existing life insurance policies and this is one of them. Secondly, a new policy, replacing existing policies, will have a two-year period in which death claims can be contested if material misrepresentations have been made by the insured on the application. Many insurance companies will investigate when death occurs within two years. This needs to be understood by clients contemplating the replacement of life insurance. In this case, only $15,000 of the new $250,000 new universal life policy is a replacement. There is also a two-year period in which benefits aren’t paid if death is the result of suicide. (See my August 1993 AAII Journal column for more complete information about policy replacement.) When the superfunded universal life policy has been issued, the cash values from the two small whole life policies will be transferred directly to the new policy so that Jeff won’t have to declare as income the gain on these small policies. The amounts transferred will increase the cost basis for the new policy. This is known as a 1035 exchange (for the Internal Revenue code section that authorizes it). Table 1 illustrates the life cycle for the superfunded low-load universal life policy Jeff will purchase. The death benefit is $265,000 plus the policy cash value. The maximum annual premium without creating a modified endowment contract policy is $7,775 (in the first year only, this includes the amount transferred from the two small policies). Jeff intends to pay this annual premium for 13 years, then begin withdrawing $5,000 annually for each of his children’s college education. When the oldest graduates from high school in 12 years the Towers will have the $5,000 withdrawal plus the $7,339 premium they won’t be paying during these college education years to help their son. Two years later their daughter will be ready for college and the withdrawals will increase. Jeff and Chris realize that this amount of funding won’t cover all of the educational costs incurred by their children, but they do expect them to work summers and part time during school.
After college education cost obligations are over, and the children are more-or-less on their own, Jeff can fund the policy with larger premium payments. (Because the death benefits are larger than the original $250,000 policy and Jeff is older, the amount that can be paid in premiums without creating a modified endowment contract is larger). The plan is to pay premiums of $15,000 until Jeff’s retirement, which they anticipate to be at age 67. Based on current pricing assumptions for the universal life policy depicted in Table 1, the Towers will be able to withdraw $30,000 annually for the rest of Jeff’s life and still have substantial death benefits remaining to transfer to their children. It appears that seven years of $30,000 withdrawals will be a tax-free return of principal (cumulative premiums paid). Then the withdrawals would be taxable. (There is a segment of the life insurance industry that aggressively sells life insurance as a retirement asset, claiming that withdrawals will be treated entirely as tax-free loans, with net zero interest costs. I am not convinced that this will work and therefore don’t plan for it. See my August 1992 AAII Journal column for more details about potential problems with the concept of tax-free and interest-free policy loans. However, if such a strategy at the time appears to be legitimate and in Jeff’s best interests, he can use it - I just don’t like to plan for it.) Estate Planning Possibilities If Jeff and Chris have accumulated sufficient invested assets at Jeff’s retirement to provide more income than they will need, they might consider transferring the $265,000 universal life insurance policy to an irrevocable trust and treating it as an inter-generational wealth transfer asset. The point is, being able to accurately predict Jeff and Chris’ needs in the future is impossible (especially as far out as retirement), but a superfunded universal life policy, originally purchased for its death benefit protection, as well as an adjunct to their investment strategy, is a versatile asset that can adapt to provide retirement income or aid estate planning goals. The ownership of the policies insuring Jeff’s life needs to be considered. Since the term insurance has no living benefits, and Jeff and Chris have an exceptionally stable marriage, Jeff decides to transfer his existing $500,000 10-year level term policy (purchased two years ago) to an irrevocable trust, and to have this irrevocable trust as the owner and beneficiary of the new $935,000 15-year level term policy as well. The purpose of the irrevocable trust is to keep the proceeds, should Jeff die while they are in force, out of his and Chris’ estates. (This is a more complicated issue in community property states. In any event, an attorney experienced in estate planning matters should be consulted for the planning and execution of estate planning documents, including irrevocable trusts.) Otherwise, if Jeff and Chris were both to die in an accident or otherwise die while their children were growing up, the term life insurance would cause a significant estate tax, which is unnecessary. Because the existing 10-year term policy must be transferred to the trust, its proceeds will be includable in Jeff and Chris’ estates for three years after the transfer. However, the new $935,000 15-year level term policy does not have this three-year problem because it isn’t a transfer. The irrevocable trust, will provide, in the event of Jeff’s death, that income and principal will be used for Chris’ benefit or for the benefit of their children in the event both Jeff and Chris have died, with the ultimate distribution of principal to the children when they are in their 30s. The superfunded $265,000 universal life policy will be owned by and payable to Jeff’s revocable trust. Ownership by the irrevocable trust makes access to the policies’ living benefits (cash values) very difficult, if not impossible, so the irrevocable trust isn’t used for this policy. A revocable trust will provide the appropriate management of the living benefits, in the event Jeff becomes incapacitated, or death benefits if Jeff dies. If during retirement the living benefits of this policy are clearly not needed, it could then be transferred to an irrevocable trust. Jeff’s life insurance program should be reviewed every few years to determine whether it continues to serve his family’s needs, the insurance companies are still sound, the universal life policy’s pricing remains competitive, Jeff’s expectations for the policy are managed, and tax law changes haven’t affected the rationale for the overall strategy. Conclusion Woven into this case study narrative are important life insurance planning issues for thirtysomething professionals to consider. They are:
This planning demonstrates that, for young professionals, there are rational reasons for the purchase of term insurance and also for the purchase of cash value insurance. Advisers who automatically recommend term insurance and life insurance salesmen who mostly recommend cash value insurance need to sharpen their professional reflexes. Reprinted with permission by the AAII Journal, November 1995, Volume XVII, No. 10.
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