Most people think of life insurance as providing protection for their family in case of the ultimate misfortune. When the policy holder dies, the beneficiary receives a payment that is designed to replace the individual’s income. The “death benefit” provides the means to allow remaining family members to continue living in their current lifestyle.

 

But life insurance has many other uses, too. It can be used to:

· Transfer wealth from one generation to another, sheltering your estate from taxes.

· Convert business assets to income after the death or retirement of an owner.

· Provide a source of financing or a steady stream of retirement income.

· Borrowing for other uses.

 

Here’s how these uses of life insurance work:

 

 

 

 

Transferring wealth. 

 

The death benefit from life insurance is exempt from federal income taxes, but not from estate taxes. However, estate taxes can be avoided by transferring ownership of the policy to a trust. 

After the insured dies, the death benefit can remain in the trust and provide ongoing income to his or her heirs. Income can go to the surviving spouse, which would keep the assets out of the spouse's estate or it can be distributed to children. The insured may use the trust as a way to distribute income to children from a previous marriage, or to control income provided to children who may be financially immature. A trustee is assigned to the trust and has control over distribution of trust assets. 

 

The life insurance trust is irrevocable; once the trust owns the policy, it owns it permanently. You can't change the beneficiary, cancel the policy, borrow against it or alter its terms in any way. Rather than transferring an existing life insurance policy into the trust, it is best to have the trust purchase a policy for you. If you transfer an existing policy and die within three years of the transfer, the death benefit will be subject to estate taxes.

 

 

Converting business assets to income. 

 

A business with multiple owners often fails after one of the owners dies, because the remaining owners typically have to buy out the share that was owned by the deceased owner. Most businesses do not generate enough cash to make such a transaction without having a negative impact on the business.

 

A spouse or one or more children typical inherits the deceased owner’s share. If an heir replaces the deceased owner in the business, the remaining owners won’t need to buy out the deceased owner’s share, but that typically does not happen.

 

To protect the business, as well as the interests of all of the owners and their heirs, a buy-sell agreement is usually established. The agreement ensures that, when a shareholder dies, the surviving shareholders will purchase the deceased shareholder's stock at a fair-market price.

The agreement also creates a vehicle for funding the purchase. Life insurance policies that name the other owners as beneficiaries are the most commonly used funding vehicle, since it makes funds available when they are needed.

 

Cash-value life insurance can also be used to create an exit strategy for a living owner. Instead of using the death benefit to purchase the owner’s shares, the owners may use the cash value to buy out the shares of the retiring owner. This approach has no impact on the business, but provides the retiring owner with a fair value for his or her share of the company and a source of retirement income.

 

 

 

  

 Life insurance has long been used as an employee benefit, especially to retain and reward key executive. Executives often receive split-dollar plans, which use cash-value life insurance to generate income during retirement.

 

Federal regulations for split-dollar plans are complex. Financial and tax advisors with experience implementing split-dollar plans can help prevent costly errors.

 

Here’s how a split-dollar plan works. The company advances money to the executive to pay premiums on a cash-value life insurance policy. To pay back the company, the executive makes the company a beneficiary. The company splits the death benefit and cash value with the executive. 

 

If the executive dies, the employer receives a death benefit equal to the amount it has paid into the policy. The executive’s beneficiaries receive the remainder of the death benefit. If the executive uses the policy to generate retirement income, the company takes a share of the policy’s surrender value when the executive retires as payback for the money it advanced the executive to pay premiums.

 

The policyholder can borrow against the policy’s remaining cash value and there normally is an interest change associated with this loan. The policyholder delays paying income taxes on the loan as long as the policy remains in force. Borrowing on the policy may be subject to restrictions, will reduce the policy’s account value and death benefit, and care must be taken to ensure that loans do not cause the policy to lapse. There also maybe fees penalties and fees associated with the use of loans and withdrawal and surrender charges may apply.

 

Employers and employees should consult with their tax advisors before agreeing to a split-dollar plan.

 

 

Borrowing. 

 

Cash-value life insurance gives policyholders an opportunity to borrow money for any need. Loans and partial withdrawals typically can be made on up to 90% of the cash surrender value of the policy, minus any outstanding loans and surrender charges depending on the policy.

 

Loans may be made after the first year of the policy and can be repaid at any time during the life of the policy. Loans and accrued interest that are not repaid are subtracted from the death benefit and surrender value. Loans are not subject to income tax while the policy is in force.

 

Loans and withdrawals will reduce the policy’s cash value and death benefit. In addition, loans may be subject to interest charges and withdrawals may be subject to partial withdrawal charges and fees.

 

Life insurance can protect your family from a financial catastrophe. But, as these examples demonstrate, it can serve many other important purposes as well.