Goal-based financial planning isn’t a new concept. Neither is diversification.
We know that we’ve historically used life insurance as a risk management tool that helps with income replacement during your working years. But life insurance also plays an important role in a diversified and comprehensive financial plan. It’s important to first establish your goals, then explore the life insurance options available to help you work toward them.
While there are more than six uses of life insurance in comprehensive financial planning, the six below are certainly the most popular, especially in light of potential changes to tax laws.
The core of why most people get life insurance is income replacement to help ensure your loved ones still have buying power and are able to stay in their home.
If you’re in your core earning years – which span from ages 35 to 55 – income replacement is especially important. During those core earning years, while there is a low risk of death, there is a high pain point should death occur.
There will be a lot – emotionally and financially – for your loved ones to deal with in the event of an untimely death. Worrying about how to pay the mortgage and pay for funeral expenses shouldn’t be among them.
Another use of life insurance is putting a policy in place and leveraging the cash value to pay tuition. But if you take this route, you’ll need a long runway or high rate of return to build enough cash to be able to pay tuition.
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If you choose this strategy, the cash value of your chosen policy doesn’t go into the expected family contribution (EFC) for consideration in financial aid, so you might get some additional help from student loans or grants.
The downside is that growth could take much longer than in a 529 investment portfolio. It’s important to talk with your financial advisor to ensure you’re using the strategy that best fits your situation.
Life insurance isn’t an investment, but it does have that savings component. Think of life insurance as another bucket – you put money into your 401(k) or you put money into your Roth IRA. Life insurance is a conservative portion of your investment portfolio that allows you to put in dollars on a tax-deferred basis, and unlike other vehicles, you get to control the flexibility and the options.
If properly put together and funded, you can take out a tax-free income over a period to supplement your retirement.
Tom Hegna, retirement income planning expert and author, said he’s moved some of his personal wealth into a cash value life insurance as a source of tax-free income in retirement.
“I think tax-free income in retirement is going to be more important every year,” Hegna said.
Life insurance can also be used to replace income from your pension or Social Security. Lastly, it can be used to cover long-term care costs. A lot of modern policies even have benefits for long-term care.
Hegna noted that in order to provide for underfunded obligations like Social Security, Medicare, Medicaid, and government and military pensions, taxes are going to have to go up.
With life insurance policies with cash value, the cash value grows tax-deferred within the contract, and beneficiaries are paid federal income tax-free. Under Internal Revenue code 1035, older contracts with cash value that aren’t performing well can be exchanged for a newer policy tax-free.
Using life insurance and buy-sell agreements upfront can help ensure continuity of the business. Whether you have two partners or multiple partners, you want to make sure that the business is passed to those who have an interest in it.
We all have an estate. Our goal with using life insurance in estate planning is to make sure you’re passing your estate efficiently and in the manner that you want to. There are always going to be expenses that come along with an estate. Life insurance provides liquidity to pay for some of those expenses and estate charges.
“Wealthy people often say they don’t need any life insurance – and they may be right in the traditional sense – however, they need a way to transfer wealth to their family in the most efficient way possible,” Hegna said. “Life insurance allows you to transfer large sums of wealth for pennies on the dollar.”
Other strategies include using an irrevocable life insurance trust to mitigate estate taxes. To go along with that, it’s important to stay up to date on potential changes in estate taxes, which will be a bigger conversation in the next 18 to 24 months.
It’s important to explore ways to use life insurance as part of your comprehensive financial plan to meet your goals. If you aren’t sure how to do that, contact a professional who can help.