RICHARD BEST
April 16, 2021
Life insurance has always been instrumental in providing families and loved ones with financial security upon the death of a breadwinner, but its unique properties can be utilized in a number of different ways. No other financial vehicle can provide the level of liquidity that life insurance does for certain life and business situations when access to capital is essential.
The Unique Properties of Life Insurance
At its core, life insurance is a simple arrangement in which a person with an insurable interest pays a premium to a life insurance company in exchange for the promise of a death benefit to be paid to the insured’s beneficiary. With permanent life insurance, the policy also offers a cash value component, allowing accumulation of the premium portions not used to cover insurance costs. What makes life insurance unique is the tax advantages afforded the policy owner and the beneficiaries.
The policy owner, which may or may not be the insured, can accumulate cash values with tax-free earnings. The owner can access cash values for any purpose, through either withdrawals or loans on the policy, on a tax-free basis. In the case of withdrawals, the policy owner does not pay federal taxes on principal, which comes out of the policy before earnings. Loans are not taxable, but if they are not repaid, the death benefit is reduced by the loan amount. Finally, the beneficiary does not pay taxes on the death benefit proceeds. The features and tax advantages of life insurance combine to provide cost-effective liquidity for both individuals and businesses.
Survivor Liquidity Needs
The most basic use of life insurance is to provide surviving family members with an immediate source of capital upon the death of a breadwinner. In many situations, a family’s assets may be tied up in its home, a retirement plan or maybe a business. Without another source of capital, the family could be required to liquidate assets to cover final expenses, pay off debt or replace lost income. Life insurance provides the instant liquidity that family members need so they can avoid selling assets.
Estate Liquidity Needs
For families with larger estates, estate settlement costs can be significant enough to require the family to sell off valuable assets, including real estate holdings. This can be especially problematic for families that need to retain a business as a going concern. The tax-free proceeds from life insurance can be used to offset settlement costs, which may include estate taxes. Families often rely on the liquidity provided by life insurance proceeds to preserve assets for future generations. Estate planners typically recommend that life insurance be held in an irrevocable trust, which keeps the proceeds from being included in the estate. Otherwise, the proceeds could increase the value of the estate, which would increase the estate tax.
Business Liquidity Needs
Businesses use life insurance as a source of capital when a key person or partner dies. In many businesses, the loss of a key person can impact revenues, and the cost of finding a replacement can be expensive. Life insurance provides the liquidity needed during the transition. If a business partner dies, the deceased’s family would be entitled to a share of the business. Life insurance, purchased as a funding mechanism for a buy-sell agreement, provides the business with the liquidity to buy out the deceased partner’s interest from the family.
Corporate Owned Life Insurance
Companies buy life insurance on the life of employees as a way to inject liquidity into the business. Companies that utilize corporate-owned life insurance (COLI) policies typically fund them with corporate earnings, but the company may not always deduct the premiums as a business expense. The cash value accumulates tax-free, and the company may access it through withdrawals or loans for any purpose. COLI is often used to fund an executive’s deferred compensation plan. At the employee’s death, the company collects the tax-free death benefit, which can be used for any purpose.
