What is the Goal? - Reasons for Purchasing Life Insurance
There are many different kinds of life insurance policy. To determine which is appropriate for you, it is important to decide the reason why the policy is being purchased.
Parents with young children will often purchase life insurance policies on their own lives. In the event that one of the parents pass away, then there will be a lump sum which will help with the cost of raising the children and paying for the college education. In a two-earner family, the loss of one of the parents will not only decrease the income of the household, but may also cause additional expenses, such as for additional child care.
Business owners often purchase life insurance on their partners or co-owners so that if the other partner or co-owner passes away there is cash to buy his or her share of the business. This allows the family of the deceased partner to obtain cash for the sale of the business interest.
Estate or inheritance taxes may be due at the time of death. Some well-off individuals have their wealth tied-up in real estate, a business or some other asset which is not easily converted into cash. The life insurance proceeds can fulfill this need, without a forced sale of an asset.
Funeral expenses are common incurred before any funds are available from an estate. In New Jersey it will take at least ten days to probate a Last Will and Testament. If there is a life insurance policy available, then the beneficiary can sign over the policy to the funeral home. Under standard assignment forms used by funeral homes, the funeral home will then process the death claim on the policy, takes its fee from the proceeds, and pay the balance of the funds to the beneficiary.
Types of Life Insurance Policies
Term life insurance works much the same way as an automobile insurance policy or a homeowners policy in that an annual premium is paid, and the coverage exist only for the term of the time period for which the premium was paid.
Once this time period on a term policy expires, if the insured person has not died, then the owner of a term policy has nothing of value (in contrast to whole life insurance, which leaves some cash reserve after the premium period expires).
As the insured person ages, and the likelihood of death during the year increases, the premium will go up. To minimize these increasing premium costs, some persons purchase "renewable term insurance", which runs for a certain number of years. At the beginning of the program the purchaser knows how much the premium will be for each year, and they can usually drop the insurance at any time if they so choose.
Renewable term life insurance policies are often purchased under a 10,15 or 20 year plan so that the amount of the premium for each year during the period is set and guaranteed by contract. However, when the number of years under a renewable term policy expires, then it may then be quite expensive to purchase an additional year of term coverage, as the insured person is now older and has a higher mortality risk.
Term life insurance is appropriate where the need for the insurance will no longer exist after a certain period of time. Once the children are raised, educated and become emancipated, there may be no further need for insurance, and the parents will hopefully have accumulated sufficient assets for their retirement.
Whole life insurance may be more appropriate when the need for the insurance which will not end after a specified period of time, then whole life will probably be more advisable. For example, life insurance policies are sometimes purchased to make cash available at the time of death to pay for estate tax or to allow the partners in a partnership for small business to purchase the interest of a deceased partner. In these types of situations, the fee for the insurance will not come to an end after a certain period of time, and a term life insurance policy could become very expensive as the insured person gets older.
Whole life insurance requires annual premiums, but after a period of time, the policy is paid up, and coverage will be in place without further annual premiums.
Depending upon the size of the cash value reserve, it will provide coverage for some extended period of time even if no further premiums are paid. Commonly with a whole life policy, the premiums are paid for a certain number of years, and then after that time period, no further premiums are required and the policy will still pay a full death benefit regardless of when the death occurred.
Naming the Beneficiary
Upon the death of the insured person, life policy proceeds do not pass according to a will, but instead pass according to the beneficiary designation signed by the owner on a form provided by the life insurance company.
Although a last will and testament will govern how a person’s assets are distributed upon death, the last will and testament does not determine how specific assets will pass if such asset has a named beneficiary.
If no beneficiary designation has been signed, then the policy proceeds may pass according to the terms of the last will and testament. However, some life insurance policies provide that if there is no signed beneficiary designation form, or if the named beneficiaries are deceased, then the proceeds will pass to a spouse, or whoever is the closest relative.
Pitfalls in Beneficiary Designations.
Many people fill out beneficiary designation forms without giving sufficient thought to the matter. Here are some examples of problems which should be avoided:
1. Often, children are named as the beneficiary of a life insurance policy or a retirement plan. However, if the children are minors then the proceeds will go to a guardian, and the child will have the right to receive all of the remaining funds upon attaining age 18. When the beneficiaries are young, or there is some other reason to doubt their ability to manage the funds, then the beneficiary should be a trust created under a written trust agreement. This will allow the trustee to manage the funds under the written directions.
2. In addition to a primary beneficiary, the form should also name contingent beneficiaries, to receive the proceeds if the primary beneficiary is deceased.
3. No beneficiary designation will be effective unless it is received by the insurance company while the insured person is alive. A beneficiary designation form can not be left in the same way as a last will and testament.
Tax Consequences.
There are a variety of tax issues which should be considered.
Income taxes are not imposed on the death benefit proceeds, with some limited exception when the proceeds are being received by a corporation.
New Jersey inheritance taxes are not imposed on the death benefit proceeds, so long a the proceeds pass to a person under a beneficiary designation form. If there is no beneficiary designation, then the proceeds may pass by the last will and testament or by intestacy, and a New Jersey inheritance tax may be imposed.
Federal estate taxes can be imposed if the total estate, including the life insurance owned by the deceased is more than the applicable exclusion, which in 2001 is $675,000. If there is a possibility of a Federal estate tax, then the owner of a life insurance policy must consider not only who should be the beneficiary of the policy, but also who should be the owner of the policy. It may be advisable to change the ownership of the policy.