Life insurance is designed to replace the income earning capabilities of a provider in the event of his or her untimely death. 

How Much Life Insurance Do You Need?

• If you are single and have no dependents, there is generally no need to buy life insurance except to cover burial costs, final expenses, and unsecured debts.
  
  
• Generally, do not insure children unless the life insurance is incidental to your medical insurance coverage at no additional cost.
  
  
• Ask your financial advisor to calculate whether your life insurance coverage is appropriate, too low, or too high.  This calculation of how much life insurance you need is commonly called a Capital Needs Analysis.  Have your advisor consider the following factors in making this determination:
  
  
  • The present value of the annual living expenses of your survivors, exclusive of nonrecurring debts and income taxes
    
    
  • The life expectancy of your surviving spouse or the expected period of support for other dependents
    
    
  • The present value of the financial needs of extended family members you may be responsible for (e.g. parents, handicapped children, and siblings)
    
    
  • The amount of your outstanding debts
    
    
  • The present value of college education and job training for your survivors
    
    
  • Burial expenses, probate, administrative costs, death taxes, and  generation skipping taxes.
    
    
  • The present value of the after-tax earned income of your survivors and the period of years it will be earned
    
    
  • The present value of your pension benefits payable to your survivors
    
    
  • The present value of your survivor's own pension benefits
    
    
  • The present value of your survivor's social security benefits
    
    
  • The present value of your investment portfolio
    
    
  • The present value of personal assets that could be liquidated for the living expenses of your survivors (e.g., automobiles, personal residence, etc.)
    
    
  • The present value of a future inheritance to be received by your survivors
    
    
  • The value of your current life insurance coverage
    
    
  • The estimated average annual inflation rate over the remaining life of your survivors.  Consider a rate of at least 4 percent.
    
    
  • The estimated tax bracket of your survivor
    
    
  • The before-tax rate of return your survivors can earn on their investments
    
    
• Based on the factors above, determine whether coverage is needed on the life of your spouse as well.  Don't overlook the economic value of a spouse who is a homemaker or breadwinner.

Term Life Insurance

• Term insurance is the least expensive form of life insurance if you believe your life insurance needs will disappear after your dependents have left home or after you have retired.  There are three types of term insurance policies available: (1) Annual Renewal Term (ART), (2) Level Term Insurance, and (3) Decreasing Term Insurance.
  
  
• Annual renewable term typically provides a level amount of life insurance coverage.  It is usually the lease expensive form of life insurance coverage.  The cost increases annually.  The policy automatically renews each year when the premiums are paid.
  
  
• Purchase annual renewable term (ART) insurance that is guaranteed renewable until you are at least age 65.  A policy is guaranteed renewable if it can be renewed regardless of your health.  ART policy premiums may increase annually.
  
  
• Level Term insurance is designed to allow the life insurance coverage and premiums to remain level for a specified period of time, usually 3, 5, 10, 15 or 20 years.  Over long periods of time, the cumulative cost of level term insurance is generally less than the cumulative cost of ART.  To be sure that the premiums remain level during the period of years,  purchase a policy that is fully guaranteed. 
  
  
• Level term insurance will be more expensive than ART if the coverage is dropped within the first few years.
  
  
• Do not purchase a policy that requires re-entry in order to renew the policy term at favorable rates.  To re-enter you must pass a physical examination.  If you don't pass, the premiums will escalate.  Most level term policies can be renewed at a level premium until age 65 at which time rates will increase annually.
  
  
• When comparing the cost of various ART and/or level premium term policies having the same benefit, select the policy with the lowest discounted present value premium amount.  Ask your financial planner to calculate this figure for you.
  
  
• To determine which level term policy will have the lowest renewal premium over the next holding period, ask your agent for the policy's 10-year net payment cost index.  The policy with the lowest index may be your better buy.
  
  
• Cash value policies are generally less expensive than term policies if the holding period is greater than 15 years.  If you are age 50 and you have a continued need for life insurance you should consider converting your existing term insurance into a cash value policy.  At about age 50 cash value policies can be less expensive than term insurance over the remainder of your life.  One major positive aspect to converting from term to a cash value policy is that most companies will not require you to pass a medical exam to be eligible for the permanent policy.
  
  
• Buy enough insurance to meet your needs.  If the only way you can presently afford the needed coverage is through term insurance, then buy term.  If your financial situation changes and you can afford the higher premiums of level term or permanent cash value insurance, then make the switch.  Some term policies may be convertible to cash value policies.
  
  
• Decreasing term insurance coverage decreases annually while the premium remains level.  It is typically the most expensive form of insurance coverage and should be avoided.

Cash Value Life Insurance

• With cash value life insurance a portion of each premium payment is set aside in a cash account that earns income.  Cash-value policies can be used as a forced savings tool if you have trouble saving money on a monthly basis.  Your checking or savings account can be automatically debited for the monthly premium.
  
  
• You may borrow the cash value in permanent policies without triggering tax on the accumulated earnings.  To qualify for tax-free borrowing, premiums must have been paid over a period of no less than seven years.  If you have a lump-sum with which to make the premium payments consider purchasing an immediate seven- year annuity that will cover the future premiums.  The interest the annuity earns will be taxable over the seven-year period using the favorable annuity income tax rules.  IRC 7702A
  
  
• Consider transferring the cash values of poor performing life insurance policies to a newer more competitive policy, to a tax deferred annuity, or another investment having a higher yield.

If you will have a permanent life insurance need consider the purchase of the following permanent or cash value policies.

Whole Life Insurance

• With a Whole Life policy you generally pay a fixed premium over the life of the policy.  The younger you are when the policy is purchased the lower the premiums.  A portion of each premium covers the cost of insurance and a portion is allocated to a savings component known as the cash value.  Income accumulated as a part of the cash value isn't taxed until the policy is surrendered.  You can borrow your cash values at a favorable interest rate without triggering taxation of the accumulated earning, or the cash values can be remitted to the insurance company to purchase additional paid-up insurance. Some policies add a portion of the cash value to the death benefit.

Universal Life Insurance

• Universal life insurance is a very flexible policy that allows you to periodically adjust the premiums and level of life insurance coverage.  The policy consists of both term insurance and a cash-value savings fund.  As long as the policy has enough cash value to cover the cost of the term insurance you can choose the amount of the premiums and when you will pay them.  You can withdraw a portion of your cash value or you can borrow against it.  However, as a good rule of thumb, never borrow more than 95% of the cash surrender value, as the remaining 5% is used to cover ongoing mortality and operating expenses.  As with whole life insurance, income accumulated in the cash value fund is not taxed until it is withdrawn.  Universal life policies can be purchased to pay both the cash value and the face amount of the policy or to pay just the face amount.  The premiums on the latter will be lower.

Variable Life Insurance

• Variable life insurance has the same features as whole life with the major difference being the option to invest your cash values in money market funds, bonds, stocks, natural resources and real estate.  Investment performance can result in fluctuating cash values and death benefits.  Depending on the insurance company, the premiums and the original face amount may remain fixed regardless of investment performance.  When considering a purchase of variable life insurance, see: INVESTMENTS: Mutual Funds Strategies.

Variable Universal Life

• Variable Universal Life is a blend of Universal Life and Variable Life insurance.  With this type of policy you can adjust the premium and death benefits as you see fit.  As with variable life insurance you can invest your cash values in various investment options.   Cash values are not guaranteed.  In addition, premiums and death benefits are flexible and not guaranteed.  When considering a purchase of variable universal life insurance, review INVESTMENTS: Mutual Funds Strategies.

Single Premium Whole Life

• With a Single Premium Whole Life policy you make one premium payment, almost all of which become the cash value of the policy.  The death benefits are much lower than a regular whole life policy because the emphasis is on increasing tax-deferred cash values.  Cash values generally grow at variable interest rates.  This type of policy is designed for individuals over age 59 who seek tax-deferred growth and tax-free death benefits.
• If you are currently uninsurable due to poor health, keep your existing cash value insurance.  However, you may want to consider borrowing against the cash value and invest the money elsewhere at a rate higher than the rate you will be charged on the loan.

Group and Supplemental Life Insurance

• Take advantage of group life insurance plans provided by your employer and  professional associations.

Group life insurance is often less expensive than other forms of life insurance coverage.  However, additional or supplemental life insurance purchased through your employer for which you pay the entire cost is often more expensive than if you purchased a policy on your own.  The reason: Supplemental Life is often more expensive because most supplemental policies do not require a physical, they guarantee insurability, and make no distinction between healthy and unhealthy applicants.  The healthy end up paying for the unhealthy who die earlier.

Joint and Survivor Life Insurance

• Consider the purchase of a joint and survivor life insurance policy.  This type of policy pays a death benefit upon the death of the second spouse. Because the death benefit is not paid until the last spouse dies, the premium is generally lower than if the policy had been taken out on either spouse individually.
  
  
• Consider a joint and survivorship policy to fund the payment of estate taxes due upon the death of the last spouse.
  
  
• Almost all survivorship policies can be split if the spouses divorce.  However, avoid policies that force you to prove that you are re-insurable at the time the policy is split.  In addition, avoid policies that impose a penalty for splitting the policy.
  
  
• Avoid policies that have term riders that make the policy sensitive to slight changes in interest rates and mortality charges.
  
  
• Examine the effect the first death has on the premium payment schedule.
  
  
• Because a Joint and Survivor policy may be in force for many years, you may want to consider a Variable Joint and Survivor policy that allows you to direct the investment of your cash values into mutual funds.  The two principal benefits of this option are the potential for higher investment returns which in turn means either lower premiums or higher death benefits, and protection from bankruptcy of the insurance company.  Bankruptcy protection is achieved because your cash values are invested outside the company in mutual funds.  If the company is seized by state regulators your cash values will still be available to you.
  
  
• Consider using a Joint and Survivor policy as a way to ensure the lives of two key employees that would create cash flow problems for your company should they both pass away.

Split Dollar Life Insurance

• If you are a closely held business owner, to minimize the cost of executive life insurance, consider a split dollar arrangement.  Under a split dollar plan both the employer and the employee share in the cost of the insurance according to a predetermined arrangement.  Upon the death of the executive, the corporation is reimbursed the premiums it paid and the balance of the death benefit is paid to the executive's beneficiaries.  Premium payments by the corporation are not deductible and they may result in taxable income to the executive.  The payment of the premiums can be split in the following ways:  Revenue Ruling 64-328
  
  
• Paid 100 percent by the corporation
  
  
• Split equally
  
  
• The company pays the premium to the extent they match the annual increase in cash value.  The executive pays the balance.
  
  
• Level premium payments by the employee for a period of years, with the corporation paying the difference.
  
  
• Employee pays the premium up to the cost of term insurance for the same level of coverage.
  
  
• Regardless of the split arrangement the employer can make an annual loan to the employee to cover his share of the cost with the proviso that the loan be repaid from the death benefits.  Alternatively, the corporation can pay a cash bonus to the employee to cover his share of the premium.  The bonus is deductible under IRC 162.  A split-dollar arrangement allows you to be flexible in choosing employees you cover and in selecting the dollar amount of coverage.
  
  
• The IRS has announced interim guidance for equity split-dollar life insurance arrangements in IRS Notice 2001-10; 2001-05 IRB 1.  The notice states that the IRS will generally accept the parties' characterization of the employer's payments under a split-dollar arrangement as long as the characterization is consistent with the substance of the arrangement, has been followed consistently from inception, and fully accounts for all the economic benefits conferred on the employee.  The IRS will permit the employer's payments to be characterized as loans (with the requirement for adequately stated interest), without resulting in additional compensation income under IRC 7872 or property transferred to the employee under IRC  83 as compensation.  If the payments are not consistently treated as loans, the parties must fully account for the economic benefits, including the employer being treated as having acquired beneficial ownership of the life insurance contract, the employee recognizes compensation income under IRC  61 and 83.  In addition, the IRS has revoked Rev. Rul. 55-747 and will no longer accept the P.S. 58 rates.  This will impact so-called "reverse split-dollar" value of current life insurance protection, but taxpayers may use the P.S. 58 rates for tax years up to the end of 2001.  This is a complex notice, the implications of which are not fully apparent at the time of this update.  You should seek current guidance before establishing an equity split-dollar arrangement.

Buy-Sell Agreements Funded With Life Insurance

If you are the owner of a closely held business consider a buy-sell agreement funded with life insurance to ensure money is available for the purchase of the corporate stock from the decedent shareholder's family.

Stock-redemption Buy-Sell Agreement

Under a stock redemption buy-sell agreement the corporation is the owner, beneficiary, and the party that pays the premiums on the policies on the insured shareholder.  The agreement binds both the corporation and the decedent shareholder's family to buy and sell, respectively, the stock at a specified price.  This amount however, must reflect the fair market value of the company.  The life insurance proceeds are used to fund this transaction.  This type of agreement may trigger the Alternative Minimum Tax (for a C Corporation) and insurance proceeds may also be subject to the claim of creditors. IRC 2703

Cross-purchase Buy-Sell Agreement

Under this arrangement, the agreement to buy-sell shares is between shareholders.  Shareholders purchase insurance on each other.  When a shareholder dies the surviving shareholder(s) receive life insurance proceeds which are used to purchase stock from the decedent's family at a fixed prearranged amount.  This amount however, must reflect the fair market value of the company.  This arrangement is easy to establish when there are less than four shareholders.  A cross-purchase buy-sell agreement provides the new owner with a higher tax cost than is available through a stock-redemption agreement.  IRC 2703

Tax Consequences of Corporate Owned Life Insurance

Life insurance death benefits and increase in cash value are generally tax-free.  However, as a result of the Corporate Alternative Minimum Tax (AMT) these benefits may be taxable.  To avoid the AMT on corporate owned life insurance consider the following:

• Convert to S corporation status.  S corporations are not subject to the AMT.
• Use a cross-purchase buy-sell agreement instead of a stock redemption agreement.  Life insurance used to fund cross-purchase agreements is owned directly by shareholders and not the corporation as is the case with a stock redemption agreement.  As a result, it is not subject to the AMT.
• If the corporation needs both key-man insurance and resources to fund a stock buyout, the AMT can be minimized if separate insurance is purchased.  The key-man insurance would be owned by the corporation and would be subject to the AMT.  The insurance to fund the stock buyout would be owned by the individual shareholders and would not be subject to the AMT.
• Set up corporate owned life insurance to pay death benefits in annual installments rather than in one lump sum.  In conjunction with proper overall AMT planning, the AMT will not be triggered.
• If the previous planning ideas are not used, the corporation can plan for the payment of the AMT by purchasing additional life insurance to cover the tax.  Alternatively, profitable corporations will be able to reduce their future regular tax by claiming a tax credit for the AMT paid on the death benefit.  The AMT, then becomes a matter of timing cash flows.

Evaluating Life Insurance Illustrations

• Be wary of illustrations and proposals for the sale of life insurance.  Be sure the interest rate and/or dividend assumptions on cash value insurance are reasonable.  Insist on a conservative illustration that uses an interest or dividend rate no greater than the rate on a five-year CD as published in the Wall Street Journal. 
  
  
• Review the cost of insurance assumptions for gimmicks or tricks.  Are expenses and mortality charges projected to be lower than what they presently are?  If so, why?  On the other hand, be wary of guaranteed mortality charges that are 30 percent higher that those used in the illustration.  The company may increase the mortality charge to the guaranteed rate which means more premium dollars will be used to pay for insurance and less will go to cash values.  Ask to review the policy illustrations prepared five to ten years ago, then inquire how the policies actually performed.
  
  
• Don't shop for policies based on illustrated values alone.  Be sure you are fully aware of all of the features and benefits.  You may prefer a more expensive policy with all the bells and whistles.  
  
  
• Universal life and whole life insurance is often illustrated and sold based on the concept of vanishing premiums.  A vanishing premium policy is one where premiums are paid for a period of years after which the policy generates enough income to become self-sustaining.  A self-sustaining policy allows the policy holder to stop making premium payments.  Be aware of best case interest or dividend rate assumptions that are used in vanishing premium illustrations.  Ask that the illustration be presented with conservative rates.  If the policy does not live up to the investment rate assumptions, the initial payments may not be sufficient to cover the on-going premiums.  As a result, the policy may self- destruct or lapse, or you may have to make additional premium payments to keep it in force.
     
• Find out the company's current interest rate, the guaranteed rate and the assumed rate used in the illustration.
  
  
• Determine the method for crediting earnings to your policy.  Do all policies earn the same amount based upon the amount the company earns on its portfolio?
  
  
• Are all policies sold in a given year grouped and credited with earnings based upon prevailing yields?  This method permits an insurance company to show illustrations based on the current year's higher yield without diluting it by the company's lower overall portfolio yield.
  
  
• Be wary of Interest Rate Bonus Illustrations.  Frequently cash-value projections show a one percent interest rate bonus for policies held 10 years or more.  Often this bonus is not guaranteed and its inclusion in the projection can dramatically distort projected cash values.  If there is to be a bonus, be sure to get the guarantee in writing.
  
  
• If you own a vanishing premium policy, annually compare the cash values shown on the most recent annual policy statement with the cash values shown on the projection when you purchased the policy.  If your actual values are lower than the projected, ask questions.  For a clearer picture, periodically ask your agent for an in-force illustration.  An in-force illustration is a projection showing how an existing policy will perform in the future based on current rates and other assumptions.  This exercise is particularly important when rates are falling.
  
  
• Before you cancel a cash value policy, determine the projected rate of return (ROR) for the policy's cash value as shown on the in-force illustration.  The ROR calculation ignores the value of the death benefit and computes the interest rate on the cash values alone.  Don't forget that the income earned by the policy is tax deferred, and in many cases may end up being completely tax-free.

Other Life Insurance Strategies

• If you own a closely held corporation or participate in a partnership, consider insuring the lives of key persons in the event that their untimely death would effect the profitability of the business.
  
  
• If you are an owner of a closely held corporation, in lieu of purchasing group term insurance consider purchasing permanent insurance for company executives through an Executive Bonus Plan.  Under this arrangement the corporation pays the entire premium which is considered to be a taxable bonus to the executive and a deductible expense by the company.  Upon retirement the employee will own a policy that provides permanent coverage and may have a significant cash value.  An executive bonus plan allows you to be flexible in choosing employees you cover and in selecting the dollar amount of coverage.
  
  
• Do not buy life insurance on a piece meal basis.  You will generally experience a reduction in premiums if you have one large policy rather than several small ones.
  
  
• Because the life insurance industry is so competitive, you should shop and compare rates at least every three years in an attempt to reduce your life insurance premium.
  
  
• It is generally not wise to buy credit life insurance because of the high premium.
  
  
• It is generally wise to avoid the purchase of mortgage redemption insurance.  Consider increasing your individual life insurance coverage to reflect the outstanding debt.
  
  
• Due to sales commissions, level term, whole life, and universal policies must be held for a long period of time in order to be cost effective.
  
  
• When comparing the cost of policies issued by different companies ask the agents to quote premiums for both standard and preferred risks.  A standard risk premium is for the applicant who is basically healthy, whereas the preferred risk premium is for someone who has exceptionally good health.  The preferred risk premium is always lower.  Be sure you know the criteria used by the insurance company to be considered a preferred risk.
  
  
• Obtain a least three proposals from three different (commissioned) agents who were recommended by other financial professionals before you purchase a policy.  Compare levels of coverage recommended, premiums, projected cash values, and recommended types of policies.  Finally, consider paying a fee-only consultant to evaluate the proposals for the best policy.

No Load (Commission) and Low Load Policies

• When purchasing permanent cash-value life insurance consider purchasing a no- load or a low-load policy in order to minimize the cost of your insurance and maximize you cash values.  No-load  or low-load policies pay little or no sales commission which generally eat up the first year's premium and part of the second year's.  As a result, with a no-load or low-load policy most, if not all, of your first year's premium is allocated to the cash value.  In addition, no and low-load policies generally pay higher net investment returns because their annual expenses are lower.  The reason: there are no sales force recruiting or training costs associated with the policy.  In addition, if you decide to bail out of the policy within the first few years, you will walk away with a lot more than if you had bought a fully loaded policy.  A no-load policy is ideal for insuring a key- employee or funding a buy-sell agreement because the corporation can recoup most, if not all, of the premiums paid if the employee unexpectedly leaves or the business is dissolved.  For more information about no-load or low-load life insurance read the Individual Investor's Guide to Low-Load Insurance Products (International Publishing).
  
  
• The following are a few of the major companies that offer no-load insurance products:  (1) Ameritus Direct (800-255-9678), (2) USAA Life Insurance Company (800-531-8000), and (3) Message Center (800-305-0135), and (4) GE Financial Service (800-874-5662).
   
• Many insurance companies now offer low-load term and universal life policies but they don't promote them because their agents that sell them have to take a 50% to 75% cut in their commissions.  If you have a good relationship with a commissioned agent and you are comfortable with the strength of the company he represents, ask if you can acquire a low-load policy through him.