Life Insurance
Life insurance is a contract between the policyholder and an insurance company regarding the life of the insured. The policyholder pays premiums; the company pays the policy’s face value (death benefits) to designated beneficiaries upon the insured’s death. Life insurance is the financial cornerstone of many estate plans for two key reasons:
- Creates an estate — all other property in an estate was accumulated during the estateholder’s lifetime; life insurance proceeds result from the estateholder’s death, filling the gap for those who have not yet accumulated wealth
- Bypasses probate — as a contract, the insurer pays death benefits directly to named beneficiaries outside the probate system, making life insurance a will substitute that creates a highly liquid estate and distributes it efficiently
Life insurance can serve many purposes in an estate plan: replacing income for survivors; satisfying existing debts; funding college tuition; providing estate liquidity; transferring capital to beneficiaries; expediting charitable contributions; indemnifying businesses for loss of key personnel; and funding buy-sell agreements.
Types of Policies
Decreasing Term & Credit Life
Decreasing term insurance provides declining death benefits over time at a constant premium — commonly marketed as mortgage insurance. However, if the goal is satisfying a mortgage, it is generally better for the policyholder to own a regular policy with their own named beneficiaries, who can then decide whether to pay off the mortgage or invest the proceeds at a higher return. The same applies to credit life policies marketed by auto dealers and credit card companies — a borrower is better served by owning and controlling a standard policy than by a credit life policy controlled by the creditor.
Non-Forfeiture Options (Permanent Policies)
The cash value of a permanent policy forms the basis of its non-forfeiture or lifetime benefits. During the insured’s lifetime, the policyholder may access the cash value through:
- Surrender — cancel the policy and receive the cash value. Taxable event subject to capital gains taxes.
- Policy loan — borrow the cash value at the interest rate stated in the policy. Proceeds are non-taxable. If the insured dies while a loan is outstanding, the death benefit is reduced by the unpaid loan balance.
- Extended term — convert the cash value into a fully paid term policy for a stated period. Same death benefit level but coverage eventually terminates.
- Reduced paid-up — use the cash value to purchase a fully paid permanent policy with a smaller face value. No future premiums required.
Policy Provisions
- Reinstatement — most policies allow reinstatement within 3–5 years of lapse by paying all back premiums plus interest and any outstanding loans, and proving insurability. Reinstating at the original (older) premium rate is usually more economical than buying a new policy.
- Incontestability — after two years from policy inception, the insurer cannot contest payment of death benefits even if the policy was obtained through misrepresentation or fraud. A new two-year period begins upon reinstatement.
- Suicide clause — if the insured commits suicide within the first two years, the insurer returns premiums paid but does not pay death benefits. After two years, death benefits are paid even in the case of suicide. Reinstatement does not impose a new suicide clause.
- Assignment — collateral assignment transfers ownership to a creditor as security for a debt; the policyholder retains other rights. Absolute assignment transfers all policy rights to a new owner.
Taxation of Life Insurance
Income Tax
Individual policyowners generally may not deduct premiums paid. Death benefits received by beneficiaries are not income taxable, with one exception: the transfer for value rule. If a policy is sold (transferred for economic consideration) and the new owner receives the death benefits, those benefits become income taxable to the recipient. This makes transfers of existing policies a significant tax planning concern.
Estate Tax — Incidents of Ownership
Life insurance death benefits are included in the insured’s taxable estate if:
- The insured retained any incident of ownership at death (or within three years of death), or
- Death benefits are paid to the insured’s estate (directly or indirectly)
To remove life insurance from the taxable estate, the insured can absolutely assign the policy to another person or to an irrevocable trust, retaining no incidents of ownership. The policy must be assigned at least three years before death — otherwise the death proceeds are included in the estate regardless of the assignment.
Gifts of Life Insurance
A person who purchases a life policy and names someone else as owner makes a taxable gift equal to the gross premiums paid. If future premiums are required, subsequent premium payments are also taxable gifts. Transfers of existing policies are valued based on whether future premiums are due: a fully paid policy is valued at its replacement cost; if future premiums remain, the gift is valued at the interpolated terminal reserve value (per IRS tables). Only absolute assignments are completed gifts for tax purposes.