Wednesday, May 11, 2011

HOW LIFE INSURANCE DIFFERS FROM OTHER TYPES OF INSURANCE

Life insurance is simple, right? You buy a policy to protect your family, you die, your family gets some money. Simple. Direct. Easy.

Not so fast. Life insurance is much more complicated than that. This chapter describes some of the myths that surround life insurance and takes a look at the main purposes of having a life insurance policy — not just as income for your survivors, but also as part of your investment portfolio, as a tax shelter, and as part of your estate planning. The following sections work to dispel the three main myths about life insurance.



I only need life insurance if I have kids

Most people think that they need life insurance only if they have a family — to ensure that their survivors aren’t left hanging if they die prematurely.
Life insurance is important for several other reasons, which you can read about in greater detail later in this chapter. Briefly, these other purposes are income replacement for a spouse to help him or her through a difficult adjustment period, as an investment, as a tax shelter, and as an estate planning tool.

Life insurance is a bad investment

Life insurance may not be the most profitable investment you can make with your money, but rarely is it a bad one. If you measure an investment only in how much you get in return, life insurance may or may not be a good investment. When you buy a life insurance policy, you put money into an account that will pay your survivors that same money, a portion of that money, or that money plus more when you die. If your survivors get more than you put in (or more than what the money could have earned elsewhere), life insurance is a good investment. If your survivors get less, it isn’t such a good investment.
However, life insurance is much more than return on investment. Life insurance provides :
  • protection for your dependents
  • Peace of mind for you
If you’re looking for a pure return on capital, you can find many more lucrative investments — even tax-deferred or taxfree options — that can yield considerably more than your life insurance policy. But the primary function of insurance is not as an investment but as protection. No other investment can offer the same amount of protection.

Life insurance is unnecessary for older people

Not very long ago, older meant “over 50.” But many people need life insurance at 50, 55, 60, or 65. Age is not always a reason to abandon life insurance. Even so-called “older” people may need income protection for their survivors if these heads of household or primary caregivers die prematurely. People in their 50s and 60s (and sometimes into their 70s) are in their peak earnings years and have family responsibilities.
You may want to give your loved ones the time to adjust to your death without having to change their normal standards of living. Today, many more people in their 50s and 60s are still supporting young children. If a woman has a child when she’s 40 or 42, for example, that child won’t finish college until Mom’s at least 62. Or suppose you have a non-working spouse and you die at the age of 60; he or she may not be able to find a job that brings in a comparable income to maintain the same standard of living.
Many older people actually need more life insurance for a number of reasons:
  • You may have less time to make up for the loss of income.
  • You may find that inflation has cut into the value of the life insurance benefit.
  • You have a greater need for estate planning as you get older because you have less time to carry out your plan.
  • You have a greater need for tax planning as you age because you’ll most likely earn more, and life insurance can play a significant part in your tax planning.
The Purposes of Life Insurance

The number one reason to have life insurance is, obviously, to protect your beneficiaries if you die prematurely. That’s clear. Every other reason is secondary — although for some people, the other purposes can take on greater importance in certain situations.

Providing protection for beneficiaries

Protecting your survivors means replacing the income you bring in if you die prematurely. If you have children, you probably spend your earnings on the costs of bringing them up. If you die, your life insurance death benefit replaces those earnings so that they won’t have to suffer financially. If you have a mortgage on your house, a life insurance death benefit can help your family stay in their home if you die.

Life insurance can help you overcome the difficulty of having to totally change your way of life because you lose half or more of your income.

Lastly, if you are part-owner in a business, the business may purchase a life insurance policy on you so that if you die, your partner can use that death benefit to buy out your share of the business from your heirs.

Using life insurance as an investment

A second purpose of having life insurance is to use it as part of your investment portfolio. Most financial advisors encourage you to balance your investments so that if one kind of investment goes down (the stock market, for example), another one will likely go up (bonds or real estate, perhaps). By balancing your portfolio and diversifying your investments, you can weather storms in one area by having some

Some life insurance policies are actually long-term investments, which you can contribute to and withdraw funds from before you die. These so-called cash-value policies — whole life (see Chapter 5) and universal life insurance are actually savings accounts that accrue a cash value over time and also pay for your protection. Although these policies don’t command the highest interest rates you can find, they are untaxed earnings, so you get a higher return than simply putting your money in a savings account on which you must pay taxes. assets in the other areas that go up or stay level.

Using life insurance as a tax shelter

Life insurance can play two roles as a tax-sheltered investment:
  • The earnings on a cash-value policy are not taxed until you take them out.
  • The proceeds of a death benefit settlement are not taxable to your survivors.
Your cash-value account yields tax-deferred income, which, in effect, increases the yield. Take a look at the example illustrated in Figure 1-1.
Now look at the fact that the death benefit is not taxable to your survivors, and using the same logic, compare the taxable versus the non-taxable return: Suppose that you currently earn $60,000 a year, and you buy a $180,000 life insurance policy to help your survivors through three years without your income. If you die, your survivors get the full $180,000, and none of it is taxed.

Although the examples may seem a bit complicated, the point is simple. Because the proceeds of a death settlement and the earnings of a cash-value life insurance policy are both taxdeferred, they serve as excellent tax shelters.

Using life insurance as part of your estate planning

In addition to serving as a tax shelter for you and your survivors, life insurance can also be an important part of estate planning — that is, dealing with how to distribute your wealth after you die.

Currently, the federal tax laws state that the first $650,000 in inheritance is federally tax-exempt (that amount increases over the next few years — see Chapter 3). Most states allow the same amount or they have no inheritance tax at all. Realistically, most people don’t need to worry much about taxes eating away their estate. Furthermore, most couples own their property and assets jointly, so surviving spouses or owners don’t have to pay inheritance taxes, even if the estate is greater than the amount allowed under the law.

But if your estate is worth more than the law allows, how do you ensure that your wealth goes to your survivors and not to the government? That’s where life insurance and life insurance trusts come in.

To do this sort of estate planning, consult an expert who can both counsel you and set up the appropriate vehicles. Briefly, here’s how it works:
  1. You set up an irrevocable life insurance trust, to which you contribute annually. The trust is, in effect, a life insurance policy, which goes to your children or survivors taxfree. You can’t withdraw that money for any reason (hence the term irrevocable).
  2. You and your spouse each leave to your children whatever the law allows at the time, so that money is also taxfree.
  3. You will the remaining amount to a qualified charity of your choice, which, by definition, is exempt from inheritance taxes. If you don’t will the remaining amount to a charity, it is considered part of your estate, and your heirs have to pay taxes on it.
In this situation, you take the IRS out of this picture. Using some of your estate, you buy a tax-free life insurance policy so that your heirs get the same amount they would have before any estate taxes — the amount equivalent to your estate. Plus, you donate a large portion of your estate to a charity rather than to the government. The only party that loses is the IRS (and another party wins — the life insurance company, which charges you a significant amount for that policy over a period of years). But your heirs lose nothing! Isn’t that the goal of estate planning?
Don’t try to wade through this complicated process by yourself. A qualified professional can help you sort through the fine details and prevent you from making a costly mistake.

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