The Role of
Life Insurance
Life insurance plays an important role in personal and business financial planning because of its mortality hedge, its advantageous tax structure and its favorable death benefit rate of return, which is arguably higher than that of other assets of comparable risk.
Self-Completion / Immediate Cash:
- The policy’s death benefit is paid in cash upon the death of the insured (for single-life coverage) or upon the death of the survivor-insured (for survivorship coverage) regardless of the policy year, as long as the policy is in force.
- Provides a “time hedge” for other estate tax “freeze” strategies to work.
Tax Efficiency. If positioned properly:
- If positioned properly, the death benefit is free of income, estate and generation skipping transfer tax.[1]
- The cash value accumulates income tax free.
- Cash value withdrawals are treated on a first-in-first-out (FIFO) basis, therefore cash value withdrawals up to the total premiums paid are generally income-tax free.
- Policy loans are income tax free.
- A life insurance policy may be exchanged for another life insurance policy (or for an annuity) without incurring current taxation.
After-Tax Death Benefit Rate of Return:
- The guaranteed after-tax death benefit rate of return of premiums paid verses after-tax death benefit received at life expectancy for a guaranteed no-lapse life insurance policy generally ranges between 4.0% and 5.5%. The rate of return is higher if the insured dies prior to life expectancy and it is lower if the insured lives past life expectancy.
- To match the guaranteed rate of return that life insurance provides at life expectancy, a taxable investment (subject to an effective tax rate of 40%) must earn between 6.66% and 9.16% before tax on a guaranteed basis to life expectancy.
[1] For federal income tax purposes, life insurance death benefits are generally paid income tax-free to beneficiaries pursuant to IRC Sec. 101(a)(1). In certain situations, however, life insurance death benefits may be partially or wholly taxable. Situations include but are not limited to the transfer of a life insurance policy for valuable consideration unless the transfer qualifies for an exception under IRC Sec. 101(a)(2) (i.e., the transfer-for-value rule); arrangements that lack an insurable interest based on state law; and an employer-owned policy unless the policy qualifies for an exception under IRC Sec. 101(j).