People who invest on a regular basis gain satisfaction from knowing that they are preparing to meet their future needs and those of their families. However, some people, including sophisticated investors, feel quite differently about paying life insurance premiums. They often tend to view these payments as mere obligations, the same as charge account bills, school tuition, or taxes. This attitude can be unfortunate because, where appropriate, certain types of life insurance can do more than provide death benefits. They also can be important financial and estate planning tools.

Income Replacement

Families may have ambitious financial goals, but in most cases the untimely death of an income earner would make these goals unattainable. By paying death benefits to replace lost income, life insurance can keep a family on its financial track. Life insurance policies can come in many forms, but the most basic distinction is between term policies and cash value (whole life) policies. Term policies offer the lowest premiums because they provide pure insurance without any investment features. Cash value policies provide at-death payouts, plus a lifetime savings feature.

Estate Creation and Protection

Life insurance paid upon the death of the insured is not subject to income tax. In addition, properly structuring a policy’s ownership and beneficiary designations can keep the benefits from being subject to estate tax. With proper planning, life insurance can provide a tax-free estate for younger families. Life insurance can also protect a family’s assets. The availability of liquid death benefits can help avoid the need to sell off estate assets to pay estate taxes or other debts.

Tax-Free Investment Growth

Cash value life insurance has other income tax advantages that make it a unique type of investment. First, a policy’s cash value builds up free of current income tax. In addition, although the cash value of traditional whole life policies grows at relatively modest fixed-interest rates, newer types of policies have been created to maximize the investment element of life insurance. Variable life policies, for example, allow the owner to select from a wide range of investment choices that may include stock funds, bond funds, asset allocation funds, government securities funds, and money market accounts. Moreover, the policy owner can switch between these different investments periodically (usually as frequently as every quarter) without being taxed on any capital gains.

A second tax advantage is that dividends and other policy distributions are treated as a tax-free return of investment up to the full amount of premiums paid. For this purpose, a policy owner’s investment is not reduced by the cost of pure death benefit protection provided by the policy. In other words, the owner can withdraw his or her original investment and keep the tax deferral on the policy’s earnings build-up.

Investing Within or Outside of a Policy

Although the above features promise tax advantages, there also are potential disadvantages to regarding cash value life insurance as an investment vehicle, and alternative investment and family income protection strategies should be considered.

As a general rule, the tax advantages associated with a cash value insurance policy will make sense from an investment point of view only if the family needs the underlying term insurance protection that must be purchased as a part of the policy. If this is not the case, the cost of the term element is a drag on the investment performance of the policy’s cash value. In this regard, purchasers of cash value policies should compare not only the guaranteed and projected investment returns of alternative policies, but also the cost of the underlying term element of each policy.

Further, cash value policies must be considered as long-term investments – their investment performance typically is poor in the first five to 10 years following purchase, and an insured who cancels a policy in the first one to three years may lose his or her total cash value investment in the policy, not just the income on the investment.

As an alternative to the purchase of a cash value policy, an individual in need of family income protection might consider buying lower cost term insurance and investing the cost difference between the policy and a like amount cash value policy in a non-insurance investment, such as mutual funds. Although this strategy could lead to investment results superior to those obtained from the purchase of a cash value policy, it also can have its drawbacks. First, the insured must have the self-discipline to actually investment the difference. Second, the insured will either have to make the non-insurance investments in a tax-sheltered vehicle, such as an IRA, or be able to receive a return on these investments that is large enough to exceed, after taxes, the tax-free return offered by a cash value policy. Finally, the insured should carefully select a term policy that is both guaranteed renewable and has a premium level over the policy term that will not make it prohibitively expensive to keep the policy in force for as long as it is needed.

The need for life insurance in a particular family’s financial and estate plan depends on many factors. The important thing to keep in mind is that different types of policies can serve a family’s evolving financial and estate planning needs.

The articles and opinions in this publication are for general information only and are not intended to provide specific advice or recommendations for any individual.

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