When used in the right circumstances, a life insurance death benefit offers clients a tax-advantaged mechanism to provide a guaranteed inheritance to beneficiaries, regardless of the performance of their non-life insurance investment portfolio.
Protecting against portfolio underperformance
The leverage offered by the death benefit of life insurance, relative to premiums paid, has long been used for annual exclusion gifts, generation-skipping tax exemptions and credit shelter trusts funded following the death of a first spouse. In all cases, life insurance allows dollars paid as premiums, at least in the early years, a death benefit generally far in excess of the premiums paid. Ultimately, clients must conduct an internal rate of return (IRR) analysis.
The IRR–readily available from any illustration system–is a way to measure two unlike streams of cash outflow and inflow by equating them to an interest rate. Where the IRR using life insurance exceeds what a client might achieve compared to another approach, life insurance may be a viable alternative use of funds, especially considering the survivor protection it also provides.
Weighing the pros
Moving a small piece of the portfolio, or income, annually into a life insurance policy offers a client a significant death benefit in relation to the premiums paid, especially in the early years.
The death benefit transfers a fixed amount to the client’s beneficiaries. The effect may be to reduce the loss associated with a client’s portfolio, especially if the cross-over with the non-life insurance assets occurs after a client’s life expectancy. Even if the cross-over point occurs a few years before a client’s life expectancy, a client still obtains the death benefit and protection in all years, as long as the policy is in force.
Knowing their beneficiaries will receive a fixed amount, clients might be able to take a different approach to their non-life insurance assets; they might either become more aggressive or more conservative.
If properly owned, the death benefit can be received free of estate tax and income tax-free.
Weighing the cons
Directing funds to premiums will reduce the return on a client’s underlying portfolio. If clients live beyond the cross-over point, they might find they would have been better not purchasing life insurance, although this may be mitigated by the policy design.
A client’s purchase is determined based on their medical and financial underwriting. Depending on the individual, the purchase might be limited.
A client’s ability to see this plan to fruition is based on the claims paying ability of the insurance carrier to meet continued premium payments.
Premium payments & policy design
Two important factors to consider when using life insurance to stabilize investments are premium payments and policy design.