Without question, maintaining adequate life insurance coverage is an essential element of risk management, especially for young families with children and individuals dependent on the earning ability of another. By creating an “instant estate” in the event of the death of the insured, life insurance protects your family financially by providing a buffer against the worst financial consequences from the untimely loss of a breadwinner.
But, like many financial tools, life insurance is not a “set-it-and-forget-it” affair. Circumstances change, and as we grow older, financial and family events occur that may call for re-evaluating the need to continue paying insurance policy premiums.
When does it make sense to reduce or drop life insurance?
Simply put, life insurance is a mechanism for shifting financial risk from the individual to the insurer. So, when the risk no longer exists or is reduced, the need for insurance does the same. For example, a breadwinner who purchased a policy to replace income or fund education expenses for minor children may consider dropping the policy or reducing coverage and premiums once the child is an adult. Similarly, a business owner who is carrying a key person policy to fund the buyout of their business partner’s interest may no longer need the policy if they have accumulated sufficient assets to complete the purchase outright or if the ownership structure of the business has changed in a way that alters the division of equity.
How can permanent life insurance fit into an estate or tax plan?
There are two basic types of life insurance: permanent life insurance (often called “whole life”) and term insurance. As the name implies, term insurance is typically purchased for a specified time period, accumulates no internal value (“cash value”), and, at the end of the term, must either be renewed or dropped (renewal often requires the payment of a higher premium than the original policy). Permanent insurance usually does accumulate a cash value and remains in force for the original face amount (death benefit) for as long as the premiums are paid (premiums typically remain the same for the life of the policy). Some permanent policies also have a “paid up” feature, when the accumulated cash value is sufficient to retain the policy in force without the payment of further premiums.
In addition to providing financial cover for young families, permanent life insurance can be beneficial in blended families for providing specific benefits to children or other beneficiaries who may be excluded from inheriting certain non-marital assets of the estate (for example, when one spouse’s children are expected to take ownership of a family business; the other spouse’s children might be compensated by becoming beneficiaries of a life insurance policy with sufficient value to equalize the inheritance). On the other hand, if one spouse’s children received death benefits due to the loss of a parent and the surviving parent subsequently remarries, those proceeds might require segregation as separate, non-marital property to ensure their use as intended by the deceased parent.
Permanent insurance may offer several other benefits for estate planning purposes. First, by naming heirs as beneficiaries, it can provide liquidity for paying estate taxes and other expenses incurred at the death of the insured. Because insurance proceeds can bypass the probate process, they can reach beneficiaries more quickly. Further, a policy can be owned by certain types of trusts (typically, an irrevocable life insurance trust, or ILIT) that remove the policy and its proceeds from the taxable estate, providing another source of funding for wealth transfer expenses.
Finally, the cash value accumulated within a permanent policy enjoys tax-free growth that can be withdrawn when the policy is canceled and can also be accessed via a policy loan that typically features low or no interest, since the death benefit of the policy serves as collateral. Unencumbered cash value continues to accumulate without taxation.
What’s the difference between term and permanent coverage in midlife?
As indicated above, the different characteristics of term and permanent coverage suggest different degrees of applicability for different needs. Since term insurance does not accumulate a cash value, it is typically much less expensive that a permanent life insurance policy with the same death benefit. This often makes term policies a cost-effective risk management solution for needs that have a specific time limitation. For example, if a business incurs debt for expansion with a five- or ten-year repayment schedule, a five- or ten-year term policy on the life of the business owner for the amount of the debt incurred would provide the business with funds to repay the loan if the business owner passed during the term of the loan. Another scenario might involve a family with children who are expected to reach adulthood within the next few years. The principal breadwinner(s) might purchase term insurance for the number of years the children are expected to remain in the home. Once the children have become independent, the policy would no longer be needed.
Owners of permanent insurance who are approaching midlife may wish to evaluate the actual risks they need to manage. Particularly if the needs of dependent children are less of a consideration or if sufficient household wealth has been accumulated, the death benefit of the policy may be a lesser consideration. On the other hand, the accumulated cash value of the policy could provide a desirable source of funding for other investments and retirement planning.
At The Planning Center, we understand that risk management is one of the pillars of a sound financial plan. We work with clients at all stages of life to evaluate and create financial strategies for limiting or avoiding the risks that can expose their families to financial harm.
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