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Life Insurance as a Planning Tool beyond a Simple Death Benefit

Life Insurance as a Planning Tool beyond a Simple Death Benefit

No estate preservation plan would be complete without a review of life insurance coverage. In some cases, live insurance coverage is unnecessary or covers too much and can be reduced to save money. In other cases, the insurance coverage is lacking and more is necessary to preserve the estate from unexpected loss. In some cases, they coverage is the desired amount but the cost can be reduced through various strategies. Finally, life insurance might have a cash equivalent value that is more desirable than the insurance death benefit.

Getting Money Out of Life Insurance without Dying

  • Borrow against the cash value of the life insurance policy.
  • Instruct the life insurance carrier to cash out the policy, based on the available cash surrender value.
  • Determine if the life insurance carrier offers an "accelerated benefits program" rider and if the insured is eligible.
  • Sell the life insurance policy in a life settlement.
  • Borrow from friends or family using the life insurance policy as collateral to secure the loan.
  • A combination of an "accelerated benefit" and a life settlement may be possible and might net more cash than either by itself!

Life Settlements

A life settlement, or senior settlement, as they are sometimes called, involves selling an existing life insurance policy to a third party - a person or an entity other than the company that issued the policy - for more than the policy's cash surrender value, but less than the net death benefit.

The purchasers become the new owners and beneficiaries for the death benefits of these purchased policies. They also take over paying the premiums. This is a legitimate investment in the death of another person. The investor will pay the insured 20% to 80% of the face value of the policy depending on the age and health of the seller.

Over the years, life settlements have become a major niche business. Investor alliances or companies that represent investors evaluate and place bids on life insurance policies for sale. These are called life settlement providers. As a general rule, they are not interested in policies less than $100,000 in face value and would prefer much larger policies. However, more recently investors are willing to purchase policies with lesser face value if everything falls into a certain formula.

These companies will not buy term insurance unless the insurance policy has an option to convert to whole life. They are primarily looking for policies that were bought years earlier for estate planning purposes but no longer fit that need. Many of these policies have become extremely expensive for the policyholder and rather than surrender the policies for their cash value, policyholders can generally get more through a life settlement.

Life settlements are also arranged through brokers who will shop for bids through a number of life settlement providers. Brokers retain a fee for their services.

Investors in life settlements could be individuals who are using their own capital to purchase policies. Investors could also be investment firms that are raising cash for buying policies from individual investors directly or indirectly through bond issues called appropriately "death bonds."

Life insurance companies do not like life settlements. Insurance companies have set premiums based on certain actuarial assumptions, one of which is that a certain number of policies will be surrendered for cash or lapsed. A life settlement causes the policy to stay in force up to the death of the insured. This means that the life insurance companies will be paying more death benefits than they intended. This responsibility for more death benefits could mean that the insurance companies lose profit or even lose money.

It is common practice among some insurance agents to find a policy that is no longer affordable but has a value in a life settlement. This money is then used to purchase a new life insurance policy that, based on projections, is more affordable. This practice may generate great commissions for the agent but may not always be in the best interest of the client. Often, the client can reduce coverage, borrow from the policy or use cash value to cover the cost of the insurance. A life resource planner will not engage in replacing life insurance policies through life settlements unless it is to the benefit of the client and not to the planner.

Review Existing Life Insurance

Life insurance for the final years of life is generally a good thing. A death benefit can be a very valuable resource for a surviving spouse. When one member of a couple dies, one of the Social Security incomes disappears -- the smaller of the two. This leaves the survivor with less income. Sometimes, pension plans also stop paying when the person receiving the pension dies.

Beneficiaries never complain about too much life insurance. The biggest challenge with having life insurance could be the ongoing cost. Some policies are paying for themselves, but the recent poor performance of long-term bonds, which insurance companies use to cover their policy reserves, often mean policies that were projected to be paying for themselves may actually have gone up in price. Higher premiums are needed to keep the policy reserves in compliance with insurance departments.

Life insurance is also an excellent way to transfer money to the next generation if there is no spouse. A death benefit is income tax-free. The biggest challenge with finding new life insurance coverage for an older person is the cost and the insurability. The older a person is, the more expensive life insurance is. At some point, the only cost advantage of buying new life insurance over keeping the same money in the bank is the tax-free death benefit.

The healthier a person is, the less expensive life insurance is. Generally, most elderly people have some sort of medical problem and in many cases would be turned down for life insurance by most companies. In recent years, companies that will guarantee insurance coverage regardless of health have become more popular. Naturally the monthly premiums on these policies are quite expensive or a lump sum premium to purchase such a policy is generally equivalent to the actual death benefit.

Many whole life policies and certain universal life policies will have enough internal cash value to actually pay the premiums on the policy. Whole life policies that also pay dividends can also apply those dividends towards the premiums. Some individuals have been paying on these policies their whole life in order to maximize the cash value of the policy. Often those policies that have been paying dividends will be increasing in the amount of death benefit as well.

As one nears the end of life, the death benefit of the policy can be more valuable for planning purposes. The cash value should be used to support the cost of the policy. Instead of taking the cash value out of the policy and surrendering it, a good whole life policy that allows cash value and/or dividends to be applied to premiums should be readjusted to reduce the premiums to the lowest level. If the policy does not allow cash value to be applied, sometimes loans against the policy can be used to pay premiums. Caution must be exercised that the loan does not get too large or it will kill the policy.

It is extremely important from time to time to review the beneficiaries on all life insurance policies. If the spouse was a beneficiary and a spouse is no longer alive and there are no contingent beneficiaries, at the owner's death, the money will pass to the estate and if the death benefit is large enough will likely have to go through probate. As one nears the end of life, passing on the death benefit of a life insurance policy might become part of a larger planning process. Care should be taken to review all life insurance to make sure that the beneficiaries or the contingent beneficiaries are properly identified. With contingent beneficiaries, it is always best to specify who gets what and when. As an example the following might be a common statement for the contingent beneficiaries: "pay all children of the deceased in equal amounts to survivors."

Life Insurance as a Planning Tool for the Final Years of Life

Life insurance companies have become more competitive in recent years for policies issued on people over age 70. Good health is still a major consideration for securing low premiums but policies have been redesigned to provide more death benefit and less cash value. Some term policies and certain universal life permanent policies are designed to provide a guaranteed death benefit up to age 95 with a guaranteed premium and no cash value at all. This design generally results in more death benefit for each premium dollar. Also, policies designed for couples - second-to-die policies - can provide a significant amount of insurance for a one-time single premium even if one of the partners is in very poor health.

An important concept to consider is that single premium life policies, with no cash value and purchased for estate planning purposes, many years in advance of applying for Medicaid, can be a valuable planning tool if the need for Medicaid arises. Medicaid does not apply the death benefit of a life insurance policy to the asset spend down rule. But the cash value of all policies owned, if any policy has more than $1,500 in face value, will count towards the asset test and could disqualify a Medicaid applicant.

As an example, a person could have $1 million of life insurance with cash value less than $1,200 and less than $500 in other resources and that would not prevent that person from receiving Medicaid. On the other hand, another person could have $20,000 worth of life insurance with $5,000 of cash value and the $5,000 would put that person above the resource limit for the state and disqualify him or her for Medicaid.

It is important to know, for planning purposes, that people who apply for Medicaid and then transfer assets to a life insurance policy, while they are going through spend down, could be in violation of their state's Medicaid transfer rules and such an act may disqualify the applicant. Life insurance as a Medicaid planning tool must be done a reasonable period in advance of applying for Medicaid.

Life insurance can be used as an alternative for funding the cost of long term care. If someone planning for the eventuality of long term care is concerned about losing assets that would normally be passed on to the children or be needed by a surviving spouse, that person can invest a portion of those assets in life insurance and leverage a death benefit payout - sometimes for up to $3.00 in death benefit for every $1.00 in single premium. The death benefit is also income tax-free.

A person creating such an estate can then use remaining assets for long term care needs in the future but still be assured that the children or a surviving spouse will receive an inheritance at death through the life insurance. And, as discussed above, if the money runs out and Medicaid starts picking up the costs, a single premium life insurance policy with little or no cash value will not disqualify the applicant owning the policy.

Another use for life insurance for the elderly is in paying the cost of final expenses such as funeral and burial. A number of companies will issue policies without any health questions for people who may not have very long to live. Most of these policies will provide little or no death benefit in the first two years after issue and so there is some risk, but most companies will also return the premiums paid if death occurs in the first two years.

Irrevocable Life Insurance Trust

Some people have a desire to leverage the value of their estate to have their children or grandchildren inherit a larger share than the cash currently on hand. One way to do this is through life insurance. If the amount of life insurance and the rest of the estate is too large, there may be estate taxes payable.

One way to reduce the estate tax burden is to transfer the life insurance to an Irrevocable Life Insurance Trust, or ILIT for short. This trust takes the insurance proceeds out of the estate for estate tax purposes. The trust owns the life insurance and the person who originally set it up, has no incidents of ownership or control over the insurance. This effectively removes it from the estate.

The ILIT will also be designated as the primary beneficiary of the life insurance and at death the proceeds will pass to the trust for the benefit of the spouse or the children for the remainder of their lives. The trust can also provide cash to pay the estate tax bill while at the same time the extra cash will not be added on to the overall estate tax burden.

Another benefit of the the trust is that since the insurance proceeds will be held in trust for the benefit of the spouse instead of going directly to the spouse, the proceeds can't be taxed in the spouse's estate either.

Finally, the irrevocable life insurance trust can go one step further and be set it up as a Dynasty Trust or Generation Skipping Trust for the benefit of the children and future generations.

Income Annuity or IRA Withdrawals to Buy Life Insurance

Tax qualified investments such as IRAs, 401(k)s, Tax Sheltered Annuities and other plans are great for saving taxes while one is working but many seniors find they don't need that money during retirement and they may want to pass on some of this tax sheltered money to their children. New "stretch IRA" rules have made it easier to reduce the immediate tax burden on these transfers at death but income tax that was deferred must still be paid. The income tax on these transferred assets can eat up a significant portion of the investment.

One way to create a tax-free transfer at death is to convert the IRA or 401(k) into a life annuity income while the owner is alive and use part of the income to purchase a life insurance policy that would equal the amount of money in the IRA that would be intended as an inheritance. A life insurance death benefit is income tax-free and thus the loss of a significant part of the account to taxes has been avoided.

Reverse Mortgage Life Insurance Strategy

Some older people don't like the idea of doing a reverse mortgage because they feel they are robbing their heirs of an inheritance or there is something inherently wrong in using up the equity in the home.

A useful strategy that typically appeals to these people is to take part of the reverse mortgage proceeds and buy a life insurance policy that has a death benefit equal to the amount of equity taken out by the reverse mortgage. A couple in their 70s could possibly buy an insurance policy for $50,000 that would pay $150,000 at the last death.

The reverse mortgage produces $150,000 in available funds. After buying the insurance, there is $100,000 in funds still available. But when the couple dies the family inherits $150,000 tax-free to replace the loss in equity to the reverse mortgage.

Life Insurance and Medicaid Planning

As mentioned above, life insurance as a Medicaid planning strategy should be done sometime well before applying for Medicaid. The reason for this is primarily to provide an aging process to the policy so that it will pay a death benefit. All these policies will not pay the full death benefit until after it has been in effect for at least two years.

Many states view the purchase of insurance during the spend down period to be a transfer for less than value which will disqualify the Medicaid beneficiary who engages in this practice.

However, there may be a risk, that insurance for estate planning months or years in advance of applying for Medicaid, will still be viewed by Medicaid as a way to accelerate the government picking up the bill for the cost of care. This type of planning must be done cautiously and with advanced knowledge of what can and can't be done. Another disadvantage is that a change in the rules may not be grandfathered and planning that was done previously could have an adverse effect. Anyone doing this type of planning must work with an individual who has the understanding and background to make sure that it is done properly.

Suppose that Jim has $200,000 of resources that would be counted for Medicaid eligibility. Suppose that a number of years prior to applying for Medicaid, Jim uses $150,000 of his assets to purchase a guaranteed issue life insurance policy on his life that will pay out $150,000 at his death.

Two years later, Jim has to go into a nursing home and apply for Medicaid. The life insurance policy has $10,000 of cash value. Countable resources for Jim are now $50,000 plus the $10,000 of cash value which equals $60,000. Jim's children are the beneficiaries of the policy. Jim must have less than $2,000 before Medicaid will cover him. Jim's attorney helps him spend the $50,000 of cash to fix up his home and buy a new car which the children will inherit. Even though Medicaid recovery will put a lien against Jim's home, the hope is there will be some value remaining after Jim dies.

Jim and his children have initiated an additional strategy with the home. The home renovation has made it possible to add 4 college students as renters in the home. They each pay $450 a month for a total rent of $1,800. This money will go towards Jim's nursing home cost. The nursing home is $5,000 a month. Jim's income is $2,500 a month after taking out allowances for insurance premiums and his personal needs. The additional rental income will be applied towards the nursing home leaving a deficit of $700 a month ($8,400 a year) that Medicaid will have to cover. Jim's life expectancy is not longer than five years at most. Medicaid's claim against the home after five years will be about $42,000 and the children will be able to keep the balance of the equity.

Jim transfers the ownership in his policy to an irrevocable life insurance trust for the benefit of his children. This creates a two-month penalty period where Medicaid will not pay for Jim's care for two months after he applies for Medicaid and has met the less than $2,000 threshold for his resources.

Jim's children have already agreed in advance to cover his private pay cost in the nursing home for two months in return for the $150,000 of death benefit. This amounts to roughly $5,000. (There are no renters yet.) One of Jim's sons has put in a bid to do the renovation on the home and will be paid as a contractor. He will use part of what he is paid to cover the two months worth of penalty.

Life Insurance-Funded Medicaid Funeral Trust

An irrevocable funeral trust consists of a single premium guaranteed issue life insurance policy that is placed inside of a special trust meeting federal and state Medicaid rules. If done properly, the money in the trust, represented by the life insurance cash value, is exempt as a Medicaid resource.

Many families may have money set aside for funeral or have bought life insurance for the same reason. For a single person, these assets would have to count towards Medicaid spend down. For a couple, even if this money for funeral purposes could be part of the community spouse allowance, the community spouse could make this money exempt and retain more cash for personal needs. A Medicaid funeral trust allows this money to be put into an account that is exempt as a resource.

In addition, many people have not planned in advance for a funeral or burial. Setting up a trust with money that is exempt for Medicaid purposes will allow them to take care of this important part of their final years of life.

It should be noted that Medicaid allows $1,500 of resources to automatically be set aside for funeral and burial. Unless, the Medicaid beneficiary is only looking at a cremation and a sprinkling of ashes, $1,500 will not cover very much. Theoretically, the $2,000 in remaining resources could also be used for final expenses. This total of $3,500 might cover a very inexpensive funeral but would never cover many of the services or items listed in the chart below.

What expenses are paid for by an Irrevocable Funeral Trust?

Basic Services of Funeral Director & Staff Other Casket
Other Professional Services Alternative Container
Embalming Outer Burial Container
Other Care of Deceased Other Services
Dressing / Cosmetology Casketing Transportation Equipment & Driver
Funeral Home Facilities and/or Staff Services Transfer of Deceased
Viewing/Visitation Funeral Vehicle/Hearse
Funeral Service Car/Limousine
Memorial Service Utility/Service Vehicle
Graveside Service Cemetery Charges
Other Merchandise Cemetery / Burial Plot
Clergy Honorarium Open/Close
Death Certificates Clothing
Musicians Flowers
Temporary Marker Obituary Notices
Stationery Package