There is no substitute for life insurance that provides an immediate estate upon a person’s death. All types of life insurance policies can provide tax-free cash upon death. The unique feature of level premium life insurance is its “affordability.” It provides lifetime coverage at the lowest level annual cost relative to other types of whole life policies. As a byproduct of level premium financing, the policy creates a tax-free or tax-deferred cash buildup. Persons desiring a combination of tax-preferred cash accumulation and life insurance may want to explore other alternatives:
A combination of a level premium deferred annuity and decreasing term insurance – Cash values accumulate in both annuities and level premium life insurance policies on a tax-deferred basis. Therefore, a combination of a level premium 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 for tax purposes. 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 owner 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. Furthermore, 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 (i.e., loan proceeds are subject to the regular income tax and may be subject to the 10 percent penalty tax). Finally, loan provisions of deferred annuity contracts are generally more restrictive than those of life insurance policies.
The annuity-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 level premium 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 insured has no incidents of ownership in the policy. The gains on the annuity contract still will be income taxable to the beneficiary and will avoid estate taxation only if the annuitant’s spouse is the beneficiary and is a United States citizen.
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 level premium 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 is not deductible. Although not the general rule, in some cases, the interest paid on life insurance policy loans may be tax deductible. The life insurance policy allows the death benefits to be transferred by operation of the contract and avoids 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 death proceeds are paid 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 level premium policy – A universal life policy can be initially configured to resemble a level premium life policy. However, in contrast with “true” level premium life policies, charges for mortality and expenses can change in the universal life policy in such a way that the policyowner could need to pay additional premiums in the future to maintain the death benefit coverage.
Reproduced with permission. Copyright The National Underwriter Co. Division of ALM