December 2000

Life Insurance Options That Protect IRA Plan Assets

By Alan D. Kahn, CLU, ChFC, CPA, The AJK Financial Group

Many advisors and clients overlook life insurance as an estate planning tool. Common objections include the following:

  • “I hate insurance companies and distrust agents.”
  • “The illustrations are confusing and never fully explain the risks.”
  • “Why pay for something that doesn’t give me a high cash value or rate of return in the short run?”
  • “I’ll buy term and invest the difference. Why give the insurance company the money when I can do as well or better on my own?”

    The best insurance product for a taxpayer’s needs depends upon individual circumstances, which include when the income or estate tax will be due. A so-called second-to-die life insurance product is usually the most cost-effective means of insuring a married couple whose taxes are due upon the second spouse’s death. If a couple wants to pay taxes upon the first spouse’s death, or if there is no spouse, a single life policy is more cost-effective. Single life policies generally cost more, but based on new products, competition, and the lower cost of mortality, some single life policies end up costing less than some second-to-die products.

    Policy Options

    Term insurance is pure insurance with no cash reserve attached. Term insurance simply provides one year of coverage on a person’s life. Some term insurance premiums increase each year; others are locked in for five, 10, 15, or even 20 years. Term insurance is most appropriate for needs that will decline or be eliminated over time, but if a policy is renewable and convertible, it locks in the insured’s future insurability.

    Whole life insurance is the most traditional life insurance product on the market. For a stipulated premium, the insurance company guarantees the death benefit and cash values in the contract. The cost of insurance or mortality charges are frozen at issue, and the insurance com pany assumes the investment risk of the cash values. Although its premium is usually higher than other permanent products, whole life provides additional benefits: The death benefit increases as cash values increase, premiums can be designed to vanish in the future (based on dividend performance), and the policyholder can borrow money from the policy to pay future premiums if individual circumstances change.

    For example, a married couple that purchased a second-to-die whole life insurance product divorced eight years later. The couple no longer wanted to pay the premiums, but the beneficiaries decided to borrow to continue the policy. Although the death benefit declined somewhat over time due to the increasing loan, maintaining the policy was still more cost-effective than cashing it in. Both insureds were no longer insurable, and no funds were available to split the policy in two. Nevertheless, the family was able to maintain the insurance.

    A combination whole life with term rider policy has the same characteristics of whole life insurance, with a rider of term insurance. The term rider amount should convert to whole life over time as the whole life dividends (which are not guaranteed) are used to purchase more whole life insurance and reduce the term portion of the policy. The premium of a combination whole life with term rider policy is lower than that of a full whole life policy, but the insurance company guarantees only the whole life portion of the death benefit.

    Universal life insurance is interest-sensitive and carries a flexible death benefit and premium. Under a universal insurance product, cash values may have little or no guarantees and are based on the insurance company’s performance. Moreover, the cost of insurance or mortality charges are subject to maximum company guarantees and continue to increase with the insured’s age, a feature that increases the cost of the policy.

    Many universal policies were sold in the early ’80s, when interest rates were unusually high. In the late ’90s, when interest rates dramatically declined, many of these policyholders were forced to either dramatically increase their premium payments or lose their death benefits.

    Competition and growing dissatisfaction with previous plan gimmicks have brought about major improvements in universal programs. For example, a universal death benefit guaranteed to age 90 or 100 can now be purchased based on a guaranteed premium. If interest rates decline or mortality charges increase beyond the insurance company’s projections, the risk of loss is transferred to the insurance company and the death benefit remains guaranteed.

    Variable universal life insurance programs are similar to universal life programs in that premiums and death benefits are flexible; however, cash values are a function of the underlying investment portfolios selected by the policyholder. Some contracts offer as many as 10 different mutual fund companies and their corresponding fund choices. Nevertheless, the policyholder retains the investment risk. For example, if the return on investments exceeds original estimates, future premiums may be decreased or eliminated. If the reverse occurs, however, higher premiums may be required to maintain coverage.

    Questions for an Insurance Agent

    What does the insurance company guarantee? Are death benefits and cash values guaranteed? If so, for how many years? The advisor or client should require company guarantees in writing rather than accept an agent’s word as gospel.

    Is the company registered to conduct business in New York State? Because New York State has the most stringent regulatory requirements for insurance companies, knowing that an insurance company is registered there is reassuring.

    How do the major services rate the insurance company? Because some services are more lenient than others, the advisor or client should review ratings from three to five different services. Major rating services include Standard and Poor’s, Moody’s, Duff & Phelps, Weiss, and A.M. Best.

    How do the dividend histories, mortality charges, and expense ratios of various companies and products being considered compare?

    Can the policyholder’s second-to-die life insurance policy be split without evidence of insurability in the event of a change in tax law or divorce? Because no one knows what the future may hold, this feature is important. If a couple divorces, the estate tax is due upon the first death. The policyholder’s options should be kept open, with the ability to split the policy if necessary.

    How do the internal rates of return on death benefits and cash values for each product compare?

    How does each product look when current dividends or interest rates are reduced? Reviewing these programs in relation to the above reductions will indicate how the product would hold up over the long run.

    What are the agent’s credentials? The agent should possess a high degree of training, exhibit technical competence, and be ethically and morally responsible. The chartered life underwriter (CLU) and chartered financial consultant (ChFC) are established professional certifications that designate technical competence in the insurance industry.

    How will medical underwriting be handled? An experienced agent will be able to present a client’s medical history to insurance companies in an organized and favorable manner.

    Last but not least, individuals considering purchasing life insurance should resolve to resist pressure and take the time necessary to become educated about available products and options. When an agent exerts pressure for a quick decision, it is time to look for a new agent.

    This article has been adapted from Ed Slott’s IRA Advisor, published by E. Slott & Company.

    Edward A. Slott, CPA

    E. Slott & Company

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