There is no substitute for life insurance of some type if an individual desires to provide an immediate estate upon his or her death. All types of life insurance policies can provide income tax-free cash upon death. The unique features of limited pay life insurance are its predictable total premium outlay and accelerated tax-favored cash buildup. It provides lifetime coverage even though premiums cease at the end of the specified premium-paying period. As a by-product of the limited-premium payment financing, the policy creates a tax-free, or tax-deferred, cash buildup.
People who desire a combination of tax-preferred cash accumulation and life insurance may want to explore several other alternatives:
A combination of a limited payment premium deferred annuity and decreasing term insurance – Cash values accumulate in both annuities and limited pay life insurance policies on a tax-deferred basis. Therefore, a combination of a limited premium payment deferred annuity and a decreasing term policy can provide levels of tax-preferred cash accumulation and death benefits similar to a level premium policy.
There are some important differences, however. The tax rules treat withdrawals, lifetime distributions, or loans from each arrangement differently. Although most ordinary life policies do not permit withdrawals, as such, if a withdrawal of cash values is permitted or the policy is partially surrendered, the amount distributed is taxed under the “cost recovery rule.” That is, the amounts are included in taxable income only to the extent they exceed the investment in the contract. In contrast, distributions from annuities are taxed under the interest-first rule. In other words, the amounts are fully taxable until the policyowner has recovered all of the excess over the investment in the contract. In addition, nonannuity distributions from an annuity contract before age 59½ may be subject to a 10 percent penalty tax. Also, loans from life insurance policies are not subject to tax; loans from annuities, if permitted, are treated as distributions and taxed under the interest-first rule. That is, loan proceeds are subject to the regular income tax and may be subject to the 10 percent penalty tax. Also, loan provisions of deferred annuity contracts are generally more restrictive than those of life insurance policies.
The annuity/decreasing term combination will require some additional and increasing premiums over the years for the term coverage. In addition, the mortality charges for term insurance coverage are typically higher than the mortality charges in a whole life policy. Finally, the death proceeds from the insurance policy generally may pass to the beneficiary entirely income and estate tax-free, regardless of who is the beneficiary, if the policy owner has no incidents of ownership in the policy. The gains on the annuity contract will still be taxable income to the beneficiary and will avoid estate taxation only if the annuitant’s spouse is the beneficiary and certain conditions are met.
A combination of investments in tax-free municipal bonds and decreasing term insurance – This combination can create a cash accumulation and death benefit similar to a limited pay policy. Similar to the cash values in a life insurance policy, bond owners may use municipal bonds as collateral for loans without any adverse income tax consequences. However, interest paid on debt secured by municipal bonds generally is not deductible. Similarly, interest paid on life insurance policy loans is rarely deductible. With the life insurance policy, the death benefits transfer by operation of the contract, thus avoiding probate. Municipal bonds are part of the probate estate and must be distributed by will. Once again, if the policyowner has no incidents of ownership, the life insurance death proceeds are estate tax-free. The municipal bonds will escape estate tax only if they are left to the spouse and sheltered by the marital deduction.
A universal life policy configured as a limited pay policy – A universal life policyowner can initially configure the UL to resemble a limited pay life policy. However, in contrast with “true” limited pay ordinary life policies, charges for mortality and expenses can change in the universal life policy in such a way that the policyowner would have to pay additional premiums in the future to maintain the face value of coverage.
Reproduced with permission. Copyright The National Underwriter Co. Division of ALM