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Insuring Affluence

By Peter McDougall

Life insurance, a key product for all those wishing to protect their loved ones, is also an important and increasingly flexible financial tool for high-net-worth individuals.

For many individuals, life insurance offers peace of mind and a way to provide for the financial security of loved ones after you are gone. The latter concern might seem less pressing for individuals with means, who often leave behind large estates that provide financial support for loved ones. Nevertheless, life insurance policies also play an important role for high–net–worth individuals.

"These policies can be a critical source of liquidity," says Etti Baranoff, associate professor of insurance at Virginia Commonwealth University. "They can also act as tax–efficient estate planning tools, among other benefits."

The multiple uses of life insurance. The tax–free death benefit holds the key to a life insurance policy’s value for high–net–worth policyholders. You can use the investment component of a policy, known as its cash value, to transfer wealth to your beneficiaries in a tax–efficient manner. Or you can focus on providing your beneficiaries with the cash flow they need while your estate is tied up in probate or its assets remain illiquid.

Death benefits can also be used to cover estate taxes if you name the estate itself as the beneficiary. "Otherwise, the beneficiaries may have to liquidate part or all of the estate to meet the liability," says Baranoff. Forced liquidation may mean that your heirs will have to sell assets at less than optimal prices. For example, they might have to sell stocks in a down market, or put real estate on the market in a downturn – and hope it sells in time.

You can also pair life insurance with annuity payments from a defined benefit plan to provide for a surviving spouse and preserve wealth for future generations. Defined benefit, or pension, plans typically include a joint survivor option. In exchange for a lower pension payment during your lifetime, your spouse will continue receiving some level of payments after you die. After your spouse dies, however, there are no further benefits.

As a potential alternative, Baranoff suggests you consider opting out of the plan’s joint survivor option. You’ll receive a higher payment during your lifetime, and you can use the extra benefits you receive to purchase a life insurance policy. When you die, your spouse will receive a tax–free lump sum. At the end of your spouse’s life, any remaining assets then become part of his or her estate, and can be passed along to future generations.

Choosing a policy. There are many different policies to choose from, each with its own strengths and weaknesses. Of the two main types of policies, term and permanent, affluent individuals generally are most interested in permanent. The reason: Though permanent policies often are more expensive, they offer the opportunity to accrue value that can be accessed later.

Following are the most common types of permanent life insurance policies:

  • Whole life policies offer fixed premiums, guaranteed cash value, and a fixed death benefit.
  • Universal life policies offer adjustable premiums, guaranteed cash value, and a minimum death benefit.
  • Variable life policies offer fixed premiums, which are invested in stocks, bonds, or other securities. While the policy guarantees a minimum death benefit, the cash value can rise or fall depending on the performance of the underlying investments.
  • Variable universal life combines elements of different policies. You have the flexible premiums and death benefit options of a universal policy along with the investment options offered in a variable policy.

Each policy type offers different guarantees and options, with trade–offs when you choose one over the other. For example, an opportunity to grow your cash value likely means a lower guaranteed death benefit.

You also face the choice of how much coverage to purchase. In each case, the size of the policy should be tailored to your specific needs. For example, if you anticipate a $5 million estate tax bill, there’s little point to buying a policy worth $3 million. Likewise, a policy geared to cover short–term cash–flow needs doesn’t need to be worth $10 million – three months’ worth of expenses should suffice.

"Your best option is to decide what benefit is most important to you and then to choose the policy that best matches that need," says Baranoff.

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