Strategic Wealth Planning: Why Affluent Individuals Invest In Life Insurance

Louis LopesWritten by Louis Lopes, CLU ChFC

Why would an affluent individual invest in life insurance?

Why do affluent families, even with significant liquidity, incorporate life insurance into their estate planning?

Wealthy individuals opt for life insurance because it has unique characteristics that distinguish it from conventional asset classes.

To illustrate these differences, let’s explore a scenario that highlights the advantages of using permanent life insurance an an asset class. Additionally, we've outlined some scenarios in which affluent families often leverage life insurance.

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Funding an Irrevocable Life Insurance Trust

Let's consider a scenario where a client faces a $1 million estate tax liability and wants to establish an irrevocable trust funded with $1 million. There are several methods for creating this $1 million, one of which is establishing a sinking fund. However, using a sinking fund presents three key risks:

1. Longevity Risk: This risk pertains to the time available to accumulate the $1 million. For example, assume the client is a healthy 65-year-old male with an expected life span to age 90, providing roughly 25 years to build the fund. Given a relatively conservation 5% return rate, taxed at 40%, and an annual deposit of $26,629 would be needed to reach $1 million by age 90.

2. Investment Risk Rate: The rate of return on any investment is uncertain and this can significantly impact fund accumulation.

3. Income Tax Risk: Sinking funds are exposed to income and capital gains taxes, and trusts face unfavorable taxation, with high rates applied even at relatively low-income levels.

Now, let’s examine the Longevity Risk further:

If the assumption is a 25-year time frame for a 65-year-old male, its essential to acknowledge that life expectancy means half of such individuals will live to age 90, while the other half will not. If our 65 year old falls into the latter category and only lives 10 years, the fund contain only $314,340. Living for 5 years would yield just $145,618.

To achieve greater than a 50% chance of success while using a sinking fund, a more rapid funding approach is required. Funding the account to age 85 would necessitate $36,132 annually to accumulate $1 million. Alternatively, funding to age 80 would require $52,201 annually.

Age 80 represents approximately one standard deviation from the expected age of 90, statistically indicating that about two-thirds of the 65-year-old pool would succeed in accumulating $1 million, but one-third would not. Now, let's contrast this estate tax liability funding method with life insurance.

Life Insurance and the Law of Large Numbers

Insurance companies leverage the Law of Large Numbers. While the outcome of a single coin flip is uncertain, repeated coin flips will result in heads and tails occurring close to 50% of the time. Similarly, predicting the lifespan of an individual is uncertain, but insurance companies, dealing with vast numbers, can precisely estimate the number of deaths in any given year.

To fund the estate tax liability with a $1 million life insurance policy, only $22,764 would be required. Furthermore, this $1 million benefit would be paid out in full, even if the insured individual were to pass away just 5 years after obtaining the policy. Insurance companies achieve this certainty due to their reliance on the Law of Large Numbers.

All other assets such as stocks, bonds, and real estate provide uncertain outcomes within known timeframes. In contrast, life insurance delivers a predictable outcome at an unpredictable time. Life insurance is the perfect tool for hedging against mortality-based risks. It aligns with our mortality-based liability in the estate tax creating a harmonious match between assets and obligations.

Life insurance also offers favorable tax characteristics. It is exempt for income tax, transfer if owned outside the estate, capital gains tax, and generation skipping tax. Furthermore, life insurance acts as a non-correlated asset when compared to other assets such as stocks, bonds and real estate. This diversification lowers an individual's overall portfolio risk.

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Situations Where Affluent Families Use Life Insurance

Here are some common scenarios where life insurance can be advantageous for affluent families.

1. Estate Tax Funding: As we previously discussed, life insurance offers a tax-favored solution to settle estate taxes.

2. Estate Equalization: In situations where one child might be inheriting an asset such as a business that represents the bulk of the estate, life insurance can be used to equalize the inheritance of the other children.

3. Buy-Sell Agreement: A buy-sell agreement is a trust established by business owners to guarantee the continuity of the business if one of the owners were to pass away. The trust is funded by life insurance which distributes the money to the deceased owner's family.

4. Charitable Remainder: These trusts typically work in conjunction with a wealth transfer trust. See the wealth transfer section below to learn more. 

5. Wealth Replacement: Life insurance can be used to replace charitable bequests seamlessly and reduce your estate's tax obligations for future generations. 

6. Survivor Income: Life insurance ensures financial security for a surviving spouse, particularly when the deceased is leaving their estate to their children, a scenario often seen in cases of remarriage.

7. Wealth Transfer: Life insurance enables the transfer of wealth to the next generation in a tax-favored manner. This article provides a breakdown of some of the most common life insurance trusts.

These challenging situations typically arise upon an affluent individual's passing, precisely when life insurance emerges as the ideal tool for mitigating mortality-related issues. It's also worth noting that term life insurance is not suitable for any of these situations.

Term life insurance only provides coverage for a set number of years, whereas these situations require a lifetime solution, making permanent life insurance the preferred choice. Guaranteed universal life insurance is the best option because it does not carry any investment risk, and it offers level premiums with a fixed death benefit.

These policies can be guaranteed until the age of 90, 95, 100, 105, 110, or even 120. As long as you pay your premiums, your coverage will be there when your loved one's need it. To learn more about these policies and the benefits they offer, see our article, "What is Guaranteed Universal Life Insurance?"

How We Can Help With Your Estate Planning Needs

JRC Insurance Group is an independent life insurance agency that represents 63 top-rated providers. We specialize with permanent life insurance policies that do not carry an investment risk making them the best option for most estate planning situations. Additionally, we offer a variety of whole and term life insurance solutions and products. 

Our agents offer at least a decade of life insurance experience and we've helped thousands of families and businesses with their life insurance needs. We'll work directly with you and your estate attorney to make sure your life insurance policy is in place when your family needs it, and set up correctly to avoid tax ramifications.

Give us a call today at 855-247-9555 to speak with one of our experts, or select your state from the map below to instantly compare permanent life insurance quotes. Our comparative shopping services are completely free and their is no cost to apply for life insurance.

Please note that we are not tax attorneys and the information provided in this article is not intended to serve as a substitute for legal advice. We always recommend speaking with a tax or estate attorney before purchasing life insurance for estate planning. To avoid potential tax liabilities, your trust must be established before you apply for coverage.

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Written by:

Louis Lopes

Louis Lopes, CLU ChFC

Chartered Life Underwriter, Licensed Life and Health Agent

Louis has been in the insurance business for over 30 years. He specializes in “high risk” cases as well as more complex coverages for long term care, disability, and estate planning.

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