Understanding Life Insurance: Types, Tax Planning, and Asset Protection

Life insurance is a crucial financial tool that provides protection and peace of mind for individuals and their families. Understanding the various types of life insurance policies, their implications for estate planning, and their potential as protected assets is essential for making informed decisions with respect to the funding process.

Types of Life Insurance

There are two main categories of life insurance: term life and permanent life.

Term Life Insurance

Term life insurance provides coverage for a specific period, typically 10, 20, or 30 years. It offers a death benefit to beneficiaries if the insured passes away during the policy term. Term life insurance is generally the most affordable option, making it popular for those seeking temporary coverage.

Permanent Life Insurance

Permanent life insurance provides lifelong coverage and includes a cash value component. There are several subtypes of permanent life insurance:

• Whole Life Insurance: Offers fixed premiums, a guaranteed death benefit, and a cash value component that grows at a fixed rate.
• Universal Life Insurance: Provides more flexibility, allowing policyholders to adjust premiums and death benefits over time. The cash value component grows based on market interest rates.
• Variable Life Insurance: Allows policyholders to invest the cash value component in various subaccounts, similar to mutual funds, offering the highest potential for growth but also the most risk.

Life Insurance and Estate Planning

Life insurance can play a significant role in estate planning, providing liquidity to pay estate taxes, fund business succession, or equalize inheritances among heirs. However, if not structured properly, life insurance proceeds can be included in your taxable estate, potentially increasing estate taxes.

Strategies for Excluding Life Insurance from Your Estate

To prevent life insurance proceeds from being included in your taxable estate, consider the following strategies:

1. Irrevocable Life Insurance Trust (ILIT): An ILIT is a trust specifically designed to own and control your life insurance policy. By transferring ownership of your policy to an ILIT, you remove it from your taxable estate.
2. Policy Ownership: Having someone else, such as your spouse or an adult child, own the policy on your life can exclude it from your estate. However, this approach can have drawbacks, including loss of control over the policy and potential gift tax implications.

Cash Value Life Insurance 

Cash value life insurance policies, such as whole life and universal life insurance, accumulate value over time that can be accessed during the policyholder's lifetime. This cash value is considered an asset, which can be both beneficial and potentially vulnerable.

State-Specific Protection Levels 

The degree of protection afforded to the cash value of life insurance policies varies widely from state to state:

• Some states offer full protection for the entire cash value of life insurance policies, regardless of the amount.
• Other states impose limits on the amount of cash value that can be protected. For example, under federal exemptions, the cash value in whole life and universal life insurance policies is protected up to $15,000.
• Many states apply conditions to their exemptions, such as requiring the policy's primary beneficiary to be a third party, not the policy owner.

Considerations for Estate Planning & Asset Protection

If your state's exemption doesn't fully cover the cash value of your policy, consider these strategies:

1. Irrevocable Life Insurance Trust (ILIT): An ILIT can be used to protect the proceeds and to lower your overall taxable estate. 
2. Limited Partnership Assignment: If your state doesn't offer sufficient protection for the full cash value of your policy, and you don't need to be concerned about your taxable estate, then assigning the policy to a limited partnership can provide an additional layer of asset protection by separating the policy ownership from your personal assets.

For any questions you may have about what to do with your life insurance policy, please do not hesitate to reach out to [e-mail]