Personal Life Insurance

Apr 19, 2022

Supplemental Life Insurance for Retirement Planning

Personal Life Insurance

Most people purchase life insurance for the death benefit protection, however, there are other benefits you may not be aware of, such as the sum of your cash value and/or high-quality chronic disease care. Supplemental Life Insurance for Retirement Planning (SLIRP) uses a life insurance policy to generate a tax-free cash flow during retirement and provide income tax-free death benefit proceeds upon the insured’s death.

This can be advantageous for someone who wants to cushion their retirement income, and avoid the contribution, vesting and participation limits that are applicable to qualified retirement plans and individual retirement accounts. The SLIRP technique also allows you to access a portion of your policy without the 10% penalty that can apply if qualified retirement plans are accessed prior to age 59½. More benefits include:

  • The income and contribution limits applicable to Roth IRAs do not exist.
  • When the insured dies, beneficiaries collect death benefit proceeds, often leveraging the funds that would otherwise be available for survivor income needs.
  • Some states have laws in place protecting life insurance cash values and/or death benefits from the creditors of the owner or beneficiaries.
  • The arrangement is flexible and can be adjusted to fit the needs of the individual.

How does it work?

Premiums are paid into a permanent life insurance policy with the intention to provide a death benefit as well as cash value accumulation for as long as the policy is in effect. A portion of the premium covers death benefit protection and the remainder, increases the policy’s cash value. Increases in the policy’s cash value does not subject it to income tax if the policy is in effect.

If retirement funds are needed, money can be withdrawn income tax-free up to the owner’s cost basis in the policy, as long as the policy does not exceed federal tax law limits. Cost basis is the total premiums paid when withdrawals exceed cost basis, the owner can take loans against the amount of money left over, with interest calculated at the current policy rate.

Upon the insured’s death, net death benefit proceeds are paid to the designated beneficiaries’ income tax-free. If a policy loan is outstanding at the time of death, the amount owed will reduce the distribution of the death proceeds.

Accessing Cash Value

Now, the amount of cash value that can be obtained changes depending on the type of permanent life insurance policy. The owner of a whole life policy can surrender additional whole life insurance coverage and take loans against the policy’s cash value. In the case of a universal life policy, an owner can make withdrawals as well as take out loans against cash value.

Tax Considerations

Estate Tax

If the policy is owned by the insured, upon their death, proceeds would be included in their taxable estate. To avoid this, one should consider having an irrevocable trust own the policy. Having your policy owned by an irrevocable trust allows the trust grantor to remove policy values from the taxable estate. Upon the insured’s death, the trustee receives estate life insurance proceeds estate tax free.

If the policy is owned by an irrevocable trust, cash value may be accessed through a spouse making a gift into the trust, loans from the trust, or funding policy premiums through a split dollar arrangement. If the policy is owned outright, the payment of premiums is not considered to be a gift. However, if the policy is owned by an irrevocable trust, the grantor can utilize gifts to the trust to fund ongoing premiums.

Estate Tax

Gift Tax

The annual gift tax exclusion amount allows a donor to give up to $16,000 (in 2022) to an unlimited number of recipients per year without being deemed a taxable gift. However, only "present interest" gifts fit the requirements for the yearly gift tax exclusion. To ensure that gifts given to an irrevocable trust qualify as present interest gifts, trusts often include limited time withdrawal provisions, giving each beneficiary a limited right to withdraw gifts to the trust.

Gift Tax

Income Tax

As mentioned above, withdrawals up to the owner’s basis in the policy are usually received income tax-free. Loans taken against policy cash value are also income tax-free as long as the policy remains in effect. Loan interest must be paid or accrued at the current policy rate.

If the policy lapses or is surrendered while the insured is alive, income tax is owed on any gain in the policy at ordinary income tax rates. If a policy loan is outstanding at the time of death, the use of the death proceeds to repay a policy loan does not cause the recognition of taxable income with respect to the policy’s death proceeds.

Income Tax

Basic Estate Planning

Regardless of an individual’s level of wealth, the failure to establish a will can be detrimental to the individual and their family. A properly structured will helps ensure that an individual’s family and financial goals are addressed during life, if incapacitated, and after death.

Important Documents

Whether the individual is single or married, the following information provides a simple introduction on essential planning the individual should take into account, as well as an overview of lifetime gifting strategies and long-term trust planning.

A will states how an individual wants their assets to be divided after death. Without a will, an individual’s property would pass as required under their state intestacy laws.

A will also enables an individual to:

  • Name an executor/personal representative, avoiding the expense and hassle of a court-appointed administrator.
  • Name a guardian for minor children, mostly eliminating the likelihood of a court-appointed guardianship.
  • Protect children’s inheritances if the individual’s surviving spouse should remarry.
  • Keep assets in trust if distributions to heirs would be inadvisable.
  • Avoid annual reporting/accounting to the probate court, and bonding costs for the executor/personal representative.

For married couples with a high net worth, a will can help assure federal estate tax benefits are preserved for the couple’s estate. Estate tax-efficient wills let a married couple take full advantage of the unlimited marital deduction and the federal estate tax exclusion ($11.7 million per individual in 2021, as adjusted annually for inflation) of both spouses. Allocation of the first deceased spouse’s exclusion amount to a trust can reduce estate tax for the couple’s combined estate, give asset protection and allow control and management by a trustee, while benefiting the surviving spouse and children.

For couples with more modest estates, estate tax-efficient wills may not be practical from the total federal tax perspective as an “all-to-spouse” will, taking into consideration the unlimited marital deduction, the potential portability of a deceased spouse’s unused exclusion, and the opportunity to have appreciated assets receive a step-up in tax basis at each spouse’s death.

Revocable Living Trust

A revocable living trust (RLT) is an arrangement where a person (the grantor) transfers ownership of property during their lifetime into a trust. An RLT can be used in place of a will by providing the distribution of assets upon the grantor's death. Unlike a will, a revocable living trust can be established to govern the distribution and use of the trust assets during the grantor’s lifetime, which makes it a useful planning tool in the grantor becomes incapacitated. The trust is like a guide for how the grantor’s assets are to be handled while alive and after death. Using an RLT can provide the benefits such as:

  • Avoidance of Probate.

    Assets owned in an RLT do not pass through the probate process, potentially making it a faster and more cost efficient way of transferring assets upon death than by a will. An RLT can also be useful if the individual owns real estate or property in multiple states through avoiding multiple probate proceedings.

  • Privacy Preservation.

    At the individual’s death, assets are passed to the heirs through probate under a will, a probate can reveal details of an estate to the public through public probate court filings. In contrast, trusts allow the transfer of assets to remain private within the constraints of the trust document.

  • Segregation of Assests.

    An RLT can be helpful for married couples with separate property acquired prior to the marriage. With community property states, the trust can help separate those assets from their community property assets.

  • Estate Tax Minimization.

    An RLT does not save estate or income taxes during life, however, provisions can be included in the trust to take advantage of estate tax exclusion amounts at death.

Durable General Power of Attorney

A power of attorney is a document that allows a person, called the Principal, to appoint another person or organization to handle affairs while the principal is unavailable or unfit to do so. The individual or organization the principal appoints is called an “attorney-in-fact” or “agent.” A general power of attorney can grant the agent limited or broad powers, as specified in the document, to manage the principal’s financial affairs and property. Powers that can be granted include:

  • Handling banking transactions and transactions involving U.S. securities.
  • Entering safety deposit boxes.
  • Purchasing and selling property.
  • Purchasing life insurance.
  • Settling claims.
  • Entering into contracts.
  • Purchasing, managing or selling real estate.
  • Filing tax returns.
  • Handling matters related to government benefits.
  • Maintaining and operating business interests.
  • Making gifts and consenting to splitting gifts made by the principal’s spouse.
  • Making transfers to RLTs.

Health Care Power of Attorney

A health care power of attorney allows the principal to assign an agent who will have the authority to make health care decisions on the principal’s behalf in the event the principal is rendered unconscious, mentally incompetent, or is otherwise unable to make such decisions.

HIPAA Authorization

A HIPAA (Health Insurance Portability and Accountability Act of 1996) authorization is also advisable. This permits medical providers to release a person’s protected medical information to another person. Individuals can include the HIPAA language in the health care power of attorney or use a freestanding document. For states with a HIPAA authorization form that is published or approved by a state regulatory agency, it is recommended to use the approved form since it will be more recognizable for medical professionals in that state.

Living Will / Advance Directive

A living will is a legal document that a person uses to make known their wishes regarding life prolonging medical treatments. The person creating the living will (the declarant) indicates which treatments they consent or do not consent in the event the declarant suffers from a terminal illness or is in a permanent vegetative state. A living will does not come into effect unless the declarant is incapacitated. Until then, the declarant will be able to dictate their own treatments.

Gifts and Bequests vs. Long-Term Trusts

People often choose to place assets in long-term trusts for the receivers’ benefit. Assets held in trust are distributed according to the trust terms. If the trust is in effect, assets are protected from creditors, litigation and divorce, as well as from mismanagement by the recipient. Distributions can also be arranged to encourage or discourage certain behavior. For example, distributions can be made upon a beneficiary graduating from college or after holding a job for a certain amount of time. A grantor could also require distributions be halted in the event of a beneficiary’s impending bankruptcy or for proven or suspected use of an abusive substance.

If desired, a beneficiary of a trust can serve as a trustee of the trust; however, if a beneficiary/trustee is granted powers to make discretionary distributions of trust assets to oneself, these powers should be limited to a reasonable standard, more specifically for their health, education, maintenance, or support, to keep the trust’s assets out of the beneficiary’s taxable estate.

From the view of asset protection, a trustee/beneficiary with rights to make discretionary distributions to him/herself may expose the beneficiary’s rights to claims of creditors. In contrast, if rights are granted to an independent third-party trustee to make discretionary distributions to the trust beneficiaries, trust assets are often more protected from the claims of the beneficiaries’ creditors.

Overall, an independent trustee can be granted unlimited discretion to allocate assets to a beneficiary without causing the trust’s assets to be included in the beneficiary’s taxable estate.

Life Insurance 101

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