Reflections on a most durable product
by Herbert K. Daroff, J.D., CFPMr. Daroff is a Contributing Editor for Life & Health Advisor. He is affiliated with Baystate Financial Planning, and can be reached at [email protected]
What do people insure?
They insure their homes and possessions against potential losses from fire, theft, personal injury, and other liabilities. They insure their vehicles against potential personal and property damage, theft, and collision. They insure their health, including eyes and teeth, as well as elder custodial care. They insure that their income will continue for their loved ones in the event of their death and disability. They also insure their life to cover debts and taxes. People buy life insurance because they love someone or they owe someone.
But, do they NEED the coverage?
Some feel that they don’t need elder custodial care insurance because they might not need the care and because they have enough other assets to self-insure. In fact, those wealthier individuals could self-insure their homes and vehicles, too, but they wouldn’t think of not having homeowners and vehicle insurance. They are more likely to use custodial care coverage than have a claim against their homeowners or car insurance. Yet, they resist long-term care coverage saying, “I may not need it.”
In reality, most of our clients don’t need the coverage they have. However, after we show them the economics of having the coverage, they buy. Insurance is mostly about wealth preservation.
Why buy life insurance?
Let’s look at my children, ages 30, 31, and 34. Should they fund their retirement with:
- Traditional tax deductible plans (IRA, 401(k), SEP, SIMPLE, etc.);
- Roth accounts (Roth IRA, Roth 401(k), if available); or
- Life insurance on either or both of their parents?
Which will likely happen first? I’ll die or they will retire? I’ll be 60 this year. When my children are 60, 61, and 64, will I be 90 or pushing up daisies?
Based on my parents, I’ll be gone. So, will my children likely net more after income taxes from traditional retirement accounts, Roth accounts, or an insurance policy on my life?
Clearly, they should consider diversification. Fund some money in each.
The Internal Rate of Return (IRR) on $IN vs. $OUT
Life Insurance Death Benefit IRR EQUIVALENT to that of:
Life insurance purchases need to be examined on a net cost basis, not on price. Term insurance has a much higher cost than permanent coverage unless you actually die when the term coverage is in-force, which, for most, won’t happen.
What is the present value, at any interest rate, of not receiving the death benefit you paid for? Go ahead, Monte Carlo that!! It’s zero!
There is a 98%, or higher, chance that you won’t collect on term life insurance. Buy term and invest the difference works if you are two standard deviations off the mean (life expectancy). You die very early or you die very late. There is a 98% chance, for most, that they will generate a greater net after tax benefit from buying permanent life insurance.
Do you insure your most valuable equipment, your real estate? Of course you do. How would your business and your life be different if you lost the use of that equipment and/or real estate?
Who are you most valuable employees? How would your business and your life be affected if you lost them? But, do you insure them? You may be able to survive the economic shortfall (self-insure), but does it make economic sense to do so when you could insure those key employees for the loss of their life or becoming disabled?
The Life Insurance Foundation for Education (LIFE) says that, “Without insurance a financial plan is just an investment account that dies with you.”
Why not use life insurance to fund the income taxes incurred on a Roth Conversion of your traditional retirement accounts at your death? If I have $1M in my retirement accounts at my death, my financial plan shows that my wife has the use of $600,000 net after taxes (in today’s 35% federal plus an assumed average 5% state income tax), or maybe only $500,000, or less, next year. However, if I have $400,000, or more, of life insurance in place when I die (what a concept, life insurance that lasts for the rest of my life), then my wife can convert my traditional retirement accounts to a Roth IRA and use the death benefit proceeds to pay the income taxes.
Remember, spousal IRA rollovers can convert to a Roth. However, inherited IRAs cannot (under current law). So, if I don’t have a surviving spouse, but I did have some warning of my death, I could even convert my traditional retirement accounts to a Roth on my death bed. The following April 15th, I look in the mirror. If I’m still there (i.e., I lived), then I can reverse the Roth election before I file my income taxes. If I’m not in the mirror (either I’m a vampire of have died), then even if I died at a New Year’s Eve party, there is sufficient time to collect the death claim and pay the income taxes on my death bed Roth Conversion.
Nobody should OWN life insurance
The only law that applies to your taxable estate is the law in effect the day you die. Who know what the federal estate tax rules will be? Who knows what the states will do? Do you want to take control over your estate planning, or leave it up to your Congress and Legislature? Why own life insurance death benefits in your taxable estate? What’s the benefit?
I would argue that no one should OWN their death benefits. Irrevocable Trusts, properly drafted for estate planning, remove assets from being accessible by your creditors and those of your children. Life insurance should not be owned personally and should not be owned inside your business (especially not if your business is a C-Corporation). Life insurance belongs in irrevocable trusts so that your purchase of coverage benefits your loved ones and not your Congress or Legislature.
And, then there is cash value
Life insurance cash value operates life a Roth Look Alike account. You fund after tax dollars, that grow tax deferred, and are accessible tax-free (if you don’t let the policy lapse).
TERM insurance + 529 Plan = Cash Value Life Insurance
(better, in many ways, than term plus 529 since the cash value is not included in the financial aid calculations, but the 529 counts as the students income, and the cash value can be used not only for qualified higher education expenses, but also for any expenses incurred by the child or the parent without restrictions)
TERM insurance + Roth Account = Cash Value Life Insurance
(accessible without any references to age 59½, and for any purpose)
Cash Value Life Insurance can be both education funding and retirement funding.
Should your cash value life insurance be whole life, universal life, or variable universal life? My answer is YES!! All of the above based on the same risk tolerances that are used to develop a diversified investment portfolio.
Here’s one particular company’s calculator to help you build the optimal life insurance portfolio for your clients. Go to your favorite search engine on the internet and enter “Life Insurance Selector”.
BE AWARE OF THE BENEFITS OF LIFE INSURANCE