How much should I own?
How do I know how much death benefit is appropriate for
my family? This is where working with a Financial Planner can help you
accurately assess how much exactly your family would need today if you were to
pass. How much of your current debts, future college costs and retirement would
you like covered if your family were to have to cover these costs without your
income? Many times life insurance agents will try to sell more insurance
coverage than is needed to earn more commission on a higher annual premium. We
always recommend consulting with Paragon Financial Advisors before buying a
policy.
What type of life insurance should I own?
Term Insurance- this is the most affordable way to purchase
a death benefit; you can lock in your premium for a set amount of years or
“Term”. Many term policies allow you to convert the policy from term or
temporary coverage to a permanent policy at the same risk class you were
approved on for your term policy years prior. But why would you want to do
that? Let’s say that Bob was approved at Select Preferred for a 20 year term
policy and a $500,000 death benefit. At year 10 of the policy being in effect,
Bob gets a rare disease that could potentially cause him to die prematurely in
the next 10-20 years. With the conversion option, Bob has the ability within
the life of the 20 year term policy to convert it to a permanent life policy at
his select preferred rating without going through medical underwriting again.
Otherwise, it’s very likely he would be uninsurable and denied life insurance
coverage.
Universal Life Insurance- this is a form of permanent
life insurance that allows for flexibility on the premium payment each year.
Universal life is generally a less expensive means to a permanent life
insurance policy offering the same death benefit compared to other forms of
permanent insurance. Additionally, VUL (Variable Universal Life) or IUL
(Indexed Universal Life) contracts offer higher potential returns than some
other fixed insurance contracts. With a VUL or IUL contract the insurance and
administrative expenses are not fixed and could increase as the insured nears
mortality age. As interest rates continue to fall since 2008, many Universal
Life policy holders from pre 2008 have received notice that their premiums are
going up. The flexibility that these life insurance companies offer comes with flexibility
on their end as well. Another disadvantage to Universal Life policies are
surrender charges to cash values, which can vary from company to company, but
many times are 10 years or more. This limits your ability to access the full
portion of the cash values until the surrender schedule has been met. Let’s
quickly explain some of the different types of Universal Life contracts.
- Guaranteed Universal Life: a “GUL” contract accrues little cash value, maintains a level death benefit and a level premium guaranteed to a certain age (Most are to age 100 or for life). This looks and acts very similar to term insurance, except it is for the insured’s lifetime.
- Variable Universal Life: a “VUL” contract does accrue cash values and has a potentially increasing death benefit with a minimum guaranteed face value that stays in force as long as the premiums are paid. The accrual of cash values and the death benefit is tied to the performance of “separate accounts” which for all intents and purposes are mutual funds. These contracts offer the policy owner market participation via these separate accounts. If the policy underperforms than it could require the policy owner to dump more money into the contract to keep it in force.
- Indexed Universal Life: “IUL” contracts are the most popular universal life policies currently sold. Unlike a VUL contract, they are actually a fixed interest rate product that offers a crediting rate tied to an index, mostly the S&P 500. Insurance companies generally offer several crediting methods: monthly sum, monthly average, a trigger method, or the most popular point to point. These policies many times offer a “floor” or minimum crediting rate to the policy of say +.5% even though the S&P 500 Index return for the year was negative. However, they also “cap” the upside potential of the return of the index and it’s important to note that the insurance companies do have the ability to lower the cap rate and the participation rate on inforce policies. Many IUL policies offer 100% participation up to 12.5%. One final note, the crediting rate applied based on the return of the S&P 500 does not include dividends, a sizeable portion of the total return over 10, 20 and 30 year time periods.
Whole Life Insurance- this is a permanent form of life
insurance that accrues cash value and has a guaranteed “face” value or death
benefit. Most whole life policies have a contractual guarantee on the return of
cash values, many of the large mutual insurers offer 4% currently. It is
important to note that this is not a 4% return on your total premium paid but a
guarantee return on the net amount applied to cash value after all expenses
have been taken out of your premium for the cost of insurance and operational
expense. In addition, whole life policies may pay “dividends” into the policy,
though these are not guaranteed. This term is not to be confused with the
dividend that you receive from some of your stocks in your investment portfolio.
Dividends from a mutual company are a return of surplus profits from their
investment earnings, mortality experience (death benefits paid) and expenses
over that time period and returned to their policy holders, hence the name
participating life insurance. When contemplating a whole life policy, generally
a well-designed one should reveal positive net cash values at the end of year 5
or 6 under the Current Assumptions Illustration.
What is the purpose of life insurance?
Risk Management: depending on how long your debts and
future expenses extend, will help you determine the appropriate length of time
you need coverage and what amount of coverage is needed. Many times term
insurance will suffice for this need.
Estate Tax: the goal of this policy is to get the highest
return of your premium on the death benefit. Many times a husband and wife will
get a joint, last survivor policy that pays on the death of the second
insured’s passing. This usually allows the insureds to get more death benefit
for the same amount of premium. Also, when dealing with estate tax issues, it’s
important to note that life insurance does offer an income tax free death
benefit, but this amount is included in the value of the estate. In order to
exclude the death benefit from the inclusion into the estate value for estate
tax purposes, an Irrevocable Life Insurance Trust or “ILIT” is often used.
Creditor Protection & Cash Accumulation: life
insurance is a creditor protected asset in the state of Texas and allows the
policy holder to enjoy creditor protection on their life insurance values. Once
you have maximized your retirement vehicles, life insurance if designed
appropriately, may be a good place to put some excess cash.
Tax deferral & Tax Free Distributions: life insurance
cash values do enjoy tax deferred growth as the policy values accumulate. In
addition, after all premiums have been withdrawn, policy holders can take out
cash via loans as a tax free distribution assuming the policy is not a Modified
Endowment Contract
What is a Modified Endowment Contract?
A ‘MEC’ is essentially a policy that’s cash value has
been “overfunded” based on the limits under the Internal Revenue Code. When a
policy is classified as a MEC, any distributions from cash values of the policy
are received on a taxable basis first or Last In First Out “LIFO” accounting
method. The interest received on premiums is taxed at ordinary income rates and
then the premium portion is returned tax free. A ‘MEC’ still benefits from a
tax free death benefit, tax deferred growth and creditor protection. To determine
if a contract is a MEC, a premium limit is set. This limit (referred to as a
seven-pay limit or MEC limit) is based on the annual premium that would pay up
the policy after the payment of seven level annual premiums. This limit is
based upon rules established by the Internal Revenue Code, and it sets the
maximum amount of premium that can be paid into the contract during the first
seven years from the date of issue in order to avoid MEC status. Under what is
known as the MEC test, the cumulative amount paid at any time in the first
seven years cannot exceed the cumulative MEC limit applicable in that policy
year.
What company should I use?
First, it’s important to make sure the life insurance
company you’re considering is a stable and functioning company able to pay
claims to its policy holders with enough reserves set aside to meet these
obligations. You never want to purchase a policy from a company that is more
sick than you are when you need them! Finding one with a Comdex score above 90
or a minimum Moody’s Investors Service rating of AA or higher is strongly
recommended.
Secondly, we recommend using a broker to shop your life
insurance need out to many different carriers. Career Agents or those working
for a specific life insurance company, have strong incentives tied to their personal
benefits to sell their company’s policies even though it may not be the very
best one for your situation.
Please contact the Paragon Financial Advisors to review
your life insurance policy(s) or help you review the available options to meet
your life insurance needs. Paragon Financial Advisors is a fee-only registered
investment advisory company located in College Station, Texas. We offer financial planning and investment management services to our clients.
