Life insurance is like a strong money helper. It’s unique because, if certain conditions are met, it guarantees to give a set amount when something specific happens when the insured person passes away. Just like things started with two choices, now there are many options and ways to use it flexibly. A life insurance lawyer can help you navigate these choices smoothly.
This article breaks down what life insurance means in legal and tax terms. We’ll explore the various types of life insurance policies out there, delve into the taxes related to income and transfers for life insurance, discuss common uses of life insurance, and touch on how the value of life insurance is determined. With the guidance of a life insurance lawyer, let’s make sense of it all in simple terms.
Life Insurance Means
Before tax laws defined life insurance, there was a common-law understanding. In a case called Helvering v. LeGierse in 1941, the Supreme Court said for something to be considered life insurance, two things were needed: risk shifting and risk distribution. Risk shifting means the person who owns the policy moves the risk of loss from the insured person’s death to the insurance company. Risk distribution means the insurance company spreads its risk of paying a death benefit across many policyholders by pooling the premiums they pay. A life insurance lawyer can help you understand these concepts better.
In 1986, Congress made a rule about life insurance in the tax code (Internal Revenue Code Section 7702). To get good tax treatment for a life insurance policy, one has to pass one of two tests. The first is the Cash Value Accumulation Test (CVAT), where there’s a limit on how much cash can build up in the policy (section 7702(b). The second is the Guideline Premium Test (section 7702(c)), where there’s a limit on how much premium you can pay compared to the death benefit. Insurance companies will only give policies that pass one of these tests. And remember, the policy also has to fit the common-law idea of life insurance. If you’re unsure, a life insurance lawyer can guide you through it.
Decoding Life Insurance Tax Rules
If the policy doesn’t pass both tests, as we discussed, the money you get is a regular income for you every year, even if you don’t take it out. This income is made up of three things: (1) the extra money your policy is worth at the end of the year, (2) the cost of keeping the life insurance coverage for the year, minus (3) the premiums you paid during the year. Understanding these rules is necessary, and a life insurance lawyer can help guide you through them.
If the policy doesn’t pass either test, it doesn’t change how the death benefit is taxed. The money from the death benefit is still considered from an insurance contract and isn’t taxed under section 101 unless there’s a specific situation discussed later that might make it not tax-free. To better understand these exceptions, consulting with a lawyer for life insurance is helpful.
Life Insurance: Risks
Life insurance comes with risks, and it’s crucial to be aware of them.
Credit Risks Ahead
Life insurance doesn’t have FDIC coverage for losses, but some state guarantee funds might help with part of the losses. It’s important to know that not all insurance companies are the same when dealing with credit risk. That’s why the company ratings matter a lot when picking a policy. If you have questions, a life insurance lawyer can provide helpful guidance.
Investment risk is about how the money in your policy is invested. For most policies, the cash is kept in the insurance company’s general account, and you don’t have control over it. Now, for variable universal life insurance policies, there are separate accounts. These accounts differ from the general one and are not at risk if the insurance company faces financial issues. The available account, however, is subject to the company’s creditors. If this sounds confusing, a life insurance lawyer can explain it.
Premium Adequacy Risk
Paying for your life insurance can be done in fixed or variable amounts. Some universal life policies offer flexibility, letting you pay when and what you want (following tax law rules). The policy owner’s job is to ensure the policy is active when they pass away. This means paying enough premiums so that the policy has more cash value than the expenses it incurs. If the policy doesn’t have enough cash, it might lapse, depending on the policy terms. If this needs clarification, a life insurance lawyer can help understand it.
Term vs. Permanent Policies
There are two main types of life insurance: term and permanent. Think of term policies like leasing a car. They provide coverage for a set time. On the other hand, permanent policies last for the insured’s entire life, like buying a car. When your term policy is up, it’s like deciding what to do with a leased car. You could buy the vehicle (convert to a permanent policy, but not all allow this), get a new lease (start a new term policy), or buy a new car (purchase a permanent policy). If this sounds confusing, a life insurance lawyer can help simplify your options.
Think of a permanent policy like owning a car you’ve bought. You can either pay for it all at once (like a single-pay permanent policy) or pay over time (similar to making premium payments on a permanent policy). You have options once you’ve paid off the car or paid up the policy. They can sell the car, use it as loan collateral, or keep driving it. With the permanent policy, you can take out the cash value, borrow against it (even if you still owe premiums), or keep the policy until the insured person passes away or it matures.
It’s good to know that policies building cash value usually take a few years before you can use it. There are other options, like life settlements, but we won’t get into that here. If you’re unsure about these choices, a life insurance lawyer can help clarify things for you.
Types of Term Policies
There are two main types of term policies: ones with a steady premium and death benefit for a set time (we call them level term policies) and others that renew each year, known as annually renewable term (ART) policies. When the time is up for a level term policy, it usually turns into a yearly renewable term policy, and the payments can go up a lot. But here’s a helpful thing: many level term policies let you switch to a permanent policy, especially at the beginning of the term. If this seems a bit puzzling, a life insurance lawyer can explain it in simpler terms.
Renewable policies are less standard than level policies. With annual renewable policies, you can renew each year without reapplying or going through underwriting. But keep in mind that the premiums get recalculated yearly, and over time, they might cost more than a level-term policy for the same period. As we get older, premiums usually go up. That’s why people often use renewable policies annually for short-term needs at a lower cost. And here’s a handy thing: sometimes, you can convert them to a permanent policy. If this needs clarification, a life insurance lawyer can help simplify it.
Types of Permanent Policies
There are two main types of permanent policies: whole life and universal life, which have four general types. Sometimes, a policy can have parts of both permanent and term policies, and we call these blended policies. They’re often used when you need permanent coverage but also extra coverage for a short time or want to handle the premiums while still having permanent coverage. If this sounds complicated, a life insurance lawyer can help break it down.
Life Insurance: Whole Life
Whole-life policies, also called ordinary life, come with fixed payments, a guaranteed death benefit, and cash value as long as you pay the needed premiums. You can take out or borrow against the cash value. If you decide to surrender the policy, you get the cash value, but there might be a charge or outstanding loan deducted. Remember from our talk about risks: the cash value of whole-life policies is in the insurance company’s general account, so it’s vulnerable to the company’s creditors. If you find this confusing, a life insurance lawyer can help clarify things.
Unlike whole-life policies, universal policies don’t have set premium payments or specific due dates, even though sales illustrations may suggest recommended payments during the sales process. They offer more flexibility with premiums than whole-life policies. The insurance company takes charges from the policy’s cash value, bringing up the premium adequacy risk we discussed. It’s up to the policy owner to ensure the policy is active when they pass away by paying enough premiums for sufficient cash value when policy expenses are charged.
The policy might lapse if the cash value is less than the charges. Usually, the insurance company will notify the owner, giving a 60-day grace period to pay higher premiums and keep the policy active. Remember, illustrations of these policies often assume constant account credits, which might only sometimes be true. So, these policies must be monitored, and updated illustrations are necessary. If the actual interest credited is less than illustrated, extra premiums may be needed to keep the policy in force for the insured person’s life. If this sounds confusing, a life insurance lawyer can help make it more transparent.
In a universal policy, the death benefit can include the face amount alone or the face amount plus premiums paid or cash value. If earnings are good, the death benefit might go up. You can surrender or borrow the cash value in universal life policies, just like whole life policies, but you can also withdraw it. Keep in mind that these policies are part of the general account. If you need help to grasp this, a life insurance lawyer can help simplify it for you.
Indexed Universal Life
Indexed Universal Life (IUL) policies are a mix of traditional and variable universal life policies, offering flexibility with premiums. They come with guarantees on policy earnings, protecting the downside and capping the upside. This is done by crediting interest based on the performance of an equity index, like the S&P 500. Once you pick an equity index, it stays the same for a while and can’t be changed. If you need clarification, a life insurance lawyer can help explain it more simply.
In indexed policies, if the earnings go above the cap, the insurer keeps the extra. But with traditional universal life policies, the insurer decides how much goes into the policy’s cash value, following a minimum crediting amount. IULs are part of the general account policies. Because these policies can get a bit tricky, it’s crucial for IUL policy owners to regularly check how their policy is doing and see if it matches the expected performance. If this seems confusing, a life insurance lawyer can help clarify it.
Universal Life with Guaranteed Coverage
No-Lapse Guarantee Universal Life (GUL) policies differ from regular universal life policies. They promise a steady premium for a guaranteed death benefit if you pay the premiums on time, even if the cash value drops to zero. GULs give up some flexibility in premiums but provide the security of a guaranteed death benefit. If you find this complex, a life insurance lawyer can help simplify things.
These policies usually only build a little cash value and limit how you can access it. GULs are like permanent level term policies, similar to level term policies with fixed annual premiums and death benefits. But, like permanent policies, they last as long as the insured person lives, as long as you meet the policy requirements. Keeping the guaranteed death benefit often comes with strict conditions, such as consistently paying the total premium amount and paying it on or before the due date. If this seems unclear, a life insurance lawyer can help understand it.
Variable Universal Life
Variable Universal Life (VUL) policies let policy owners put premiums into mutual fund-like investments, called subaccounts. This means the owner takes on the investment risk. VULs share many features with universal life policies, like flexible premiums. The death benefit can change, covering the face amount or the face amount plus cash value. Unlike the other insurance types mentioned, VULs are a different product, kept separate. This means they’re not at risk from the insurance company’s creditors. If this is confusing, a life insurance lawyer can help clarify it.
Life Insurance: Features
Besides the death benefit and cash value, policies might come with extra features that could be useful. Some are part of the basic policy, but others need a rider added, usually with an additional charge. Remember that these riders have limits and things they don’t cover, and it can differ with the insurance company or the specific rider. If you need more clarification, a insurance lawyer can help explain them better.
Common riders include:
- Guaranteed Insurability Rider: This lets you buy more coverage without new checks at certain ages or events like marriage or having a child.
- Waiver of Premium Rider: If the insured becomes disabled, this rider means premiums are waived. Depending on the policy and rider type, the premium might be treated as paid, keeping the cash value growing.
- Long-Term Care/Chronic Illness Access: Allows access to the death benefit if the insured needs long-term care or faces chronic illness.
Transfer of Insured Rider: Handy for business situations, it lets you swap a policy for a new one on a different insured. This reduces charges on the new policy’s first year, boosting cash value. There are conditions, like underwriting the new insured and the owner having an insurable interest. It’s not a tax-free exchange; it’s like surrendering the old policy and buying a new one for tax purposes. Any gain on the original policy is taxable.
Life Insurance: Ratings
A life insurance policy, even a term one, is meant to be there for many years. It’s crucial to consider how likely the insurance company can pay the death benefit when the insured person dies. Different rating agencies, like A.M. Best, Moody’s, Standard & Poor’s, and Fitch, assess the ability of insurance companies to fulfill claims. They examine the company’s assets, cash flow, investments, and expenses. Each agency has its way of doing this and uses its scale.
When you check the ratings, it’s essential to understand what each rating means according to the agency and where the insurer stands on that scale. Not all companies get rated by all agencies. Remember that these ratings can change quickly—look at AIG during the 2008 financial crisis as an example. It’s a good idea to check the credit rating of carriers every year. If this seems confusing, a life insurance lawyer can help make it simpler.
Life Insurance: Key Terms
- Policy: This is like the agreement that lays out what the insurance company will pay if something big goes wrong for the policyholder.
- Insured: This is the person who gets the insurance benefits. But, in life insurance, the “insured” is the one whose life is protected. The person who receives the benefits is called the “beneficiary.”
- Benefit: This is the money or help an insurance company gives when something terrible happens.
- Claim: When something wrong does happen, this is the request you make to get the benefits.
- Premium: These are the payments the insured person makes to the insurance company at a particular time.
- Coverage: This is the amount of potential loss, liability, or risk the insurance covers.
- Insurance Agent: This is a licensed person who can sell insurance in a specific area.
Although some may view hiring a lawyer for insurance as an extra cost, it’s an investment that pays off. A lawyer can break down the complex details and legal language, ensuring you fully grasp your agreement. If you need assistance creating a thorough insurance contract, don’t hesitate to contact our Insurance Risk experts. They can guide you to ensure you’re well-protected in challenging situations.