Life Insurance Needs Analysis

Life insurance is the wealth that never was, the future paychecks that will never be, and the financial security that is born upon a breadwinner’s death. Unless and until that unfortunate event, the majority of families live from paycheck to paycheck and, during their lifetimes, will neither inherit wealth nor acquire it through normal means. Generally speaking, the breadwinner’s death means the financial demise of the family and the loss of future hopes and dreams.

Do you think the following statement is true? “The majority of American families are underinsured.” Most will probably agree. If we assume that it is true, then why? Well, there are a myriad of reasons why, but let’s talk about all the reasons why the insurance professional serves an important and necessary role in the financial planning process to reverse that truism.

In 1999, the total number of deaths in the United States was 2,391,399. The age-adjusted death rate, which eliminates the effects of the aging of the population, was 881.9 per 100,000 population or 0.88%. Age-adjusted death rates for major race groups per 100,000 were as follows: White – 860.7; Black – 1,147.1; American Indian – 716.1; Asian or Pacific Islander – 517.5. The age-adjusted death rate among males of all races was 1.4 times greater than females. Life expectancy at birth was 76.7 years. (www.cdc.gov).

From an income perspective, the IRS reports that the median adjusted gross income (AGI) for the 2001 tax year was $28,117 (www.irs.ustreas.gov/taxstats). Let’s assume for the moment that the 1999 AGI was the same as 2001. Let’s also assume that one out of every one hundred deaths, or only one percent, were breadwinners. This would amount to a financial loss of $672.39 million. Over ten years, it would amount to $6.7239 billion. That’s a major loss in productivity, which affects the economic wealth of the country. If one also considered the “economic multiplier effect” by using a factor of ten, then the economic effect would be ten times greater. More importantly, it’s a financial loss to the families that would have received that money for their sustenance. There’s only one viable source that can cost effectively replace that loss – life insurance.

Why are people more interested in discussing investments than life insurance? Why are people more willing to spend money on some sort of investment before taking care of their life insurance needs? Death is guaranteed; the return on one’s investments is not. Public perception has a lot to do with it. Let’s take a poll and ask the public to compare and rank two professionals, an investment advisor and life insurance salesperson. The qualitative analysis would be based on the perceived importance of the professional’s role as the individual’s financial planner or consultant. The answer is quite obvious based on watching any news program that interviews a financial professional who is giving his perspective on things. When was the last time you saw a program where the interviewer said, “This is Joe Brown and he is a life insurance salesman for XYZ Life.” Overall, the investment advisor would be perceived as having a more important role. Yet, if one looked at the financial benefits received from purchasing products from both professionals, life insurance would come out on top, not only from a dollar for dollar perspective but also for playing a major financial role during a time of crisis and grief.

There’s a Bible verse that says, “If anyone does not provide for his own, and especially for those of his household, he has denied the faith, and is worse than an unbeliever,” I Timothy 5:8. Needless to say, those are pretty harsh words put politely. If that phrase were written in modern terms, it would probably call the aforementioned person the scum of the earth. There are multiple ways to provide for one’s family; however, life insurance is the only financial tool that provides more money for fewer dollars at the worst time.

Even when one does provide for the family, a common mistake is to have insufficient amounts of life insurance. One of the most common reasons is the lack of money. This can sometimes be fueled by the fact that an insured may be paying too much for the wrong kind of life insurance, the result being underinsured. The next most common reason is ignorance. Most people do not know how much life insurance they should have.

This course will take the reader through multiple topics that the insurance professional can use to advise buyers of life insurance in making informed decisions to adequately provide for their families.

Without a doubt, life insurance is one of the most important assets of any estate or financial plan. In planning for this asset, all potential insureds should seek professional counsel; otherwise, the results could be disastrous. If one were to discuss the topic of life insurance with a dozen life insurance professionals, one would probably get a dozen different opinions. Only the client and his insurance advisor can properly determine what best suits the client's needs; and, many times, the insurance advisor is also the financial planner and investment advisor. When purchasing life insurance, among other things, one must consider the intended purpose or need, the type of life insurance that will fulfill that need, and the amount needed.

Life insurance can meet business needs as well as personal needs. Since a business may comprise the largest piece of one's estate pie, it only stands to reason that life insurance can become a major planning tool for that business. For business owners, some major estate planning concerns are continuation of the business after death, replacement of key employees, equalization of inheritance for heirs not interested in the business, or the buyout of other partners.

Many businesses start out as the brainchild of the owner and may stay small or grow to large international corporations. No matter how one's business grows, most owners want it to continue to succeed long after they are gone. Since family members may be associated with the business, its successful continuation may play a large part in the financial survival of the heirs.

Goodwill is strongly attached to the business owner or other family members who have successfully earned the respect of customers. When any business owner dies, there is a loss of goodwill and an interruption in the smooth operation of the business. The owner is also a primary employee and is hard to replace. His duties may expand further than can be defined in a job description. After an owner's death, the transition can be very costly from the loss of goodwill, temporary declining sales, personnel replacement and associated perks, hiring costs, training and supervision, etc. Life insurance can be the needed cash infusion to make up for the lost cash flow and additional expense during a transition.

The loss of a key employee can create the same financial problems similar to the death of the business owner. A key employee is usually an officer of the company, supervisor or administrator in a high level position. His responsibilities are very broad; his training and experience is hard to replace; and, he plays a key role in the business' success. Depending upon the type of business, replacing a key employee may require an ad in the local newspaper or hiring an executive headhunter service to perform a nationwide search. Either way, losing key employees can be very costly and life insurance is the most effective tool in meeting those costs.

It's not uncommon for a business owner to have an adult child interested in the family business and another child who is pursuing his dreams elsewhere. The one who is interested in the business may want to take over when dad or mom retires. He may have even gone to college or business school to become better prepared. He may already be a key employee who is the heartbeat of the business. Well, this creates a dilemma for the parent/owner. At death, does the owner will that the business be sold and the proceeds be split between the kids? Not hardly! Does he will that the uninterested child take a place of power alongside the other child who has been putting his heart and soul into the business all of his adult life? Not hardly! Does he disinherit the other child? Not hardly! Just because the other child has pursued other interests, it does not mean that he is unworthy of his inheritance. The best solution to equalizing an inheritance in this predicament is to make the uninterested child the beneficiary of life insurance on the owner's life having a death benefit equal to the fair market value of the business. This will allow the one child to completely inherit the business and continue its success and allow the other to receive an equal amount while pursuing his own interests.

Some businesses form partnerships or corporate entities with multiple partners. This poses two buyout problems. First, how do the heirs of a deceased partner receive their fair share; and, second, how do the remaining partners buy the deceased partner's share? If partners do not address these two problems and provide for some mechanism to effect a solution upon a partner's death, then a whole new set of problems arise which will be discussed first. Let's assume XYZ Company, a multi-million dollar manufacturer, has three partners and there is no buyout mechanism in place. One of the partners, the office manager, dies and is survived by his wife who is the bookkeeper of a local retail store. Since she is the legitimate heir and no provisions have been made to buy the deceased partner's share, she now becomes the new partner. It's a rare instance where the spouse of a deceased partner can step in and take up the reins. Most spouses wouldn't want the job; remaining partners don't want the spouse as a partner; the synergy has totally changed; personalities usually clash; and, a whole myriad of other problems can exist. The only feasible solution is to have a contractual agreement in place called a buy-sell agreement or cross-purchase agreement. The type of agreement depends upon the makeup of the business and number of partners but the result is the same. Upon the death of a partner, the remaining partners are contractually obligated to buy the deceased partner's share and the deceased partner's survivors are contractually obligated to sell.

Even though partners may create a buy-sell agreement, they may fall short in providing a way of funding the agreement. This is called an unfunded plan. In other words, when a partner dies, where do the remaining partners get the cash to buyout the deceased partner's survivors? If there is no funding mechanism, the remaining partners may be bound to a payment schedule that can severely drain cash from operations with the potential of bankrupting the business. The cheapest and easiest way to fund a buy-sell agreement is with life insurance. If cash value life insurance is used, the policy can play a multiple role by providing for interim cash flow needs or cash to buyout a retiring partner.

The most common reasons people buy life insurance are for survivorship income and debt payoff. In evaluating this need, a breadwinner can be perceived as a money machine. By his actions, he produces a weekly paycheck that pays for all the things his family needs. When he is physically or mentally unable to produce money, either because of death or disability, something must replace his lost ability.

For lack of planning, some families may have to depend upon the other spouse going to work or having to work at more than one job. Others may have to move in with relatives and some may even become the beneficiaries of the social programs of the government. If one was fortunate enough to have previously saved or invested, those resources could be used. However, in the case of premature death, it is unlikely there would be sufficient monies to make a long-term impact. Whatever the outcome, the results will be unpleasant if there is inadequate life insurance. For premature death, life insurance IS the only cost effective solution. It has a discount nature, meaning that it can provide large sums of money for a fractional cost.

Survivorship income needs are dependent upon numerous factors of which only a financial advisor can assist in identifying. The amount of need is also dependent upon the character and financial makeup of the survivors. For example, a surviving spouse with 3 small children would have a much greater need for a longer period of time than a single survivor who is retired.

In addition to providing survivorship income, life insurance fulfills a tremendous liquidity need. Besides the need for income, survivors may have additional needs or special needs. The deceased family member may have been performing special functions in the home that now must be hired out. For example, a survivor may need assistance for daily activities because of mental or physical impairments. There is also a cost attached to dying. Prior to death, one may have had a long-term illness. Medical insurance has co-insurance and deductibles that are out of pocket expenses. There may have been extensive travel for medical treatment. Treating an illness may cause loss of work and wages for both spouses. After one dies, there is always a period of bereavement in which survivors are not working. Settling an estate also has various costs associated with it.

Parents and grandparents pay for college in numerous ways; however, death brings many financial endeavors to a halt. Lastly, many estates are relatively illiquid. This means there may be sufficient assets but not readily available cash. For example, families may have a long history of inherited land from the early days. It has only been four to five generations ago when the west was settled and family members still closely hold many of those possessions. It is not uncommon for survivors to be forced into selling illiquid assets such as real estate at fire sale prices in order to settle a deceased’s estate.

There is a minority in the insurance profession that provide shortcut services for their clients, meaning they use fast and short formulas to quickly determine a client’s life insurance needs. Even though a quick sale is the result, and the amount might meet most needs, such a pursuit inevitably overlooks some component that was not considered while the breadwinner was alive, but arose after death. We are going to take a look at many of those components. However, before we delve into the various components that may be included in one’s life insurance needs, we’ll discuss the types of life insurance first.

In a course such as this, one would normally start with other topics and then lead up to a discussion about the various types of life insurance. However, since subsequent topics will incorporate the types of life insurance into the discussion, we reversed the order to set the proper foundation. We’ll start with a general discussion of life insurance; however, we won’t delve into the minute details of the various types. Even though there are more types of life insurance than will be discussed here, for all practical purposes, there are only a few general types to deal with. From these, there are a myriad of variations, packagings, nuances, bells and whistles. Once an insurance professional knows the appropriate type(s) needed for a client, he or she can then meet those needs by tweaking the particular type of life insurance with the appropriate packaging.

By far, term insurance is the easiest to understand and explain. Term is similar to fire insurance - it pays when there is a claim, nothing else. In terms of simplicity, it’s the ticket. There are no other bells and whistles. A life insurance policy is a unilateral contract whereby once the policy is approved the insurance company is bound by the terms of the contract unless it lapses from nonpayment of premiums.

At any specific point in time, term insurance is always the cheapest type of life insurance. However, depending upon the length of an insured’s holding period, term insurance may not be the most cost effective. Since that statement sounds a little oxymoronic, we’ll elaborate. In regards to cost-effectiveness, any type of life insurance should be considered from one or both of the following perspectives. The first perspective relates to cost alone. If cost was the sole criteria and no other considerations mattered, then term insurance would always be the choice. The second perspective is the success of one’s life insurance plan. Policy owners purchase life insurance to meet certain objectives, such as to pay for mortgage payments or estate taxes. If that’s the case, then the success of one’s insurance plan depends upon him being financially able to pay premiums until the “event” passes or takes place. For example, if a forty-year-old corporate executive buys life insurance to pay for his estate taxes, then he must be able to pay policy premiums until his death. In that regard, statistics indicate he may have to pay premiums for almost forty years. Even though the purchase of life insurance is mainly for current needs, one must still consider the long-term scheme of things. If everyone knew the day of his or her death, then it would be simple. In this example, however, if all he has is term, premiums and guaranteed renewability in the latter years become serious issues.

The type of term insurance is identified by the time frame in which one chooses and whether the amount remains level or decreases. For example, one may choose a one-year term with the option to renew each subsequent year at the insured's then current age. This is called annual renewable term, aka ART. On the other hand, one may want to lock in for a longer time frame such as ten years. Price breaks are built into longer-term periods. A ten year term sets a premium rate that is averaged and fixed over ten years; and, total premiums paid is less than renewing an ART for ten years. The same scenario applies to twenty-year term or even thirty-year term.

Term insurance is best for those needing the most life insurance for the least cost within a known time frame. Typically, young families fall in this category. Others may use term insurance to supplement other life insurance in order to fulfill a substantial temporary need or one that can even last until retirement.

One of the major problems with term insurance is its inability to be guaranteed renewable for one's lifetime. Most insurance companies will not renew term policies past the age of 70. Even if one could renew, the cost would be prohibitive. In a nutshell, term insurance may not fulfill one's life insurance needs where longevity is concerned nor is it highly recommended for estate planning purposes.

Permanent life insurance is designed to last over one's lifetime. There are many variations and names such as whole life, ordinary life, paid-up life and endowment. Permanent is the generic term to represent all of them. The terms whole life and ordinary life are used interchangeably. Endowments and paid-up policies have a special packaging. The premium for permanent life insurance remains constant and is higher than term insurance at the time of purchase. Depending upon one's holding period or time commitment, whole life may be cheaper over the long haul. This, of course, does not take into consideration other planning concepts such as "buy term and invest the difference" or the "time value of money." However, it does take into consideration cost effectiveness as previously discussed.

In order for premiums to remain constant, individuals called actuaries make statistical calculations to determine a premium rate, inclusive of many assumptions, that will prevent the policy from lapsing over an insured’s whole life, which is typically considered age one hundred. One of the side benefits of this type of design is the cash value. This is the equity portion of the policy that helps keep premiums constant and is also available for the policy owner's use. Since they are part of the contract, cash values are guaranteed to the policy owner. If one ever borrows any of the cash values, the death benefit is reduced dollar for dollar. In permanent policies, the death benefit consists of two components: life insurance and cash values. The amount of life insurance is the amount that the insurance company is at risk in paying. The cash value is the equity component and belongs to the owner of the policy. If the insured dies, the policy owner gets the total of the two, the cash value component and life insurance component, which always equals the original policy amount (death benefit) unless there had been prior loans. In the early years of the life insurance industry, insurance professionals were not privy to the “inner-workings” of permanent policies and inadequately informed clients of the nature of the policy. Upon death, many beneficiaries thought that the insurance company kept the cash values, assuming it was supposed to be an additional payment. That was never the case. The structure of a permanent policy was of such design to enable level payments over one’s lifetime. It only stands to reason that as one ages, the chances of death increases. From the insurance company’s perspective, its cost to insure that risk goes up as well. Term insurance is a perfect example of that. It would be ridiculous for an insured to assume that as he ages, his actual “pure” cost remains the same. For example, let’s say a seventy-year-old male bought a $100,000 permanent policy when he was fifty. It would be ridiculous for him to assume that his actual cost of insurance is the same as it was twenty years prior. Cost of insurance and premiums are two different things. Cost of insurance is the amount required by the insurance company to insure the risk of the insured dying. Premiums paid on a permanent life insurance policy include the cost of insurance with an excess being the supply train for the cash values. As the cash value component increases, the risk component decreases, both equaling the original death benefit.

In the past and present, permanent policies have been sold as savings plans, forced savings, college savings, retirement plans, etc. However, the cash accumulation is part of the design that enables level premium payments throughout an insured’s lifetime. It is only a side benefit and should not be construed as a replacement for sound investing or saving. The internal rate of return of the cash value component is the result of policy and actuarial design, is very low, and is not tied to any particular crediting rate.

One of the best features of permanent life insurance is that the premiums are guaranteed to remain constant. For long terms and estate planning purposes, this is a real positive. It is also the biggest tradeoff for those wanting cheap life insurance and lots of it. With the privilege of constant premiums for the long term, one gives up the ability to buy lots of cheap life insurance for the short term.

Another misunderstood item of permanent life insurance is dividends. A life insurance dividend is not a dividend as in the investment sense. For example, when an investor owns stock or a mutual fund and a dividend is paid, then it is considered a distribution of profit and is taxable to the recipient; life insurance dividends are not.

The non-taxability of dividends was determined in the early 1900’s by the U.S. Treasury Department by declaring dividends to be a return of premium. If it were anything other than a return of premium, it would have been declared profit and thus making it taxable. Dividends are not guaranteed like cash values. The determination to pay dividends is an internal, corporate decision and is dependent upon corporate profitability.

Many insurance companies have had a long history of paying regular, dependable dividends. It was just like money in the bank. Public perception and dependability was strong and the thought of any company lowering, much less skipping, dividend payments was unthinkable. Well, the transition into the twenty-first century busted that perception bubble and many companies found themselves lowering dividends and the reality of that fact had an unpleasant welcome with the buying public.

Policy owners can use dividends in many ways. They can; of course, just let the dividends stay with the insurance company, earn interest and be available for some future use. They can also use dividends to buy additional life insurance that is ‘paid-up.’ One of the most popular uses of dividends is to have them pay for premiums. The thought behind this was that the future estimated dividends would equal or exceed the required premium, thereby phasing out the need to make any more premium payments. The industry called this event “vanishing premium.” Of course, as previously mentioned, dividends are not guaranteed and most companies made the mistake of promoting vanishing premium as a benefit. When dividends did not pay out as originally promoted and premiums did not vanish, many insurance companies got nailed. Needless to say, the term “vanishing premium” is no longer used and has been replaced with a “modified payment option,” which more correctly represents it as just another dividend option – to pay premiums.

In many ways, universal life insurance is a cross breed between permanent and “buy term and invest the difference” (discussed in next chapter). Since the late 70s, these two concepts and those who promoted them have been at a constant battle. For those advocates of buy term and invest the difference (BTID), the selling point was that one could purchase much more life insurance for far less money than permanent and invest the difference. This difference, if invested properly, should accumulate to such an amount that it would surpass the cash values of any permanent plan as well as replace one’s need for life insurance because, based on certain growth estimates, it would eventually equal or surpass the original death benefit. In such a case, the insured would be considered self-insured and have no need for life insurance. Since the returns on universal life insurance were dependent upon the life insurance company’s crediting rate, cash value growth could not compete with alternative tax-qualified investing. Because of universal life’s tax-deferred growth, it could compete with some alternative taxable investments.

These shortcomings were put to rest with the introduction of variable universal life (mentioned below) because all the attributes of BTID were incorporated into these new plans. However, there are still other trade-offs for both sides of the argument, so one can only look at a factual comparison with his financial advisor to select the one that has the best fit.

For universal life insurance, one needs to be familiar with some terms already mentioned. In term and permanent life insurance, the amount of the initial life insurance and the death benefit were considered one in the same. However, in universal life insurance, initial death benefit has a slightly different meaning. Unlike permanent life insurance, the cash value component of universal life insurance is a separate component and is tied to some sort of crediting rate. Since cash values are a separate component, this means the life insurance, which is now called risk, is also a separate component. The reason insurance companies changed the name to risk is that it better represents what premiums are being paid for - the risk of dying. If one dies, the insurance company must contractually pay the risk amount. In addition, the policy owner owns the cash values; therefore, they must be paid as well. In summary, death benefit is the combination of two components, risk and cash value. In some ways, this is the same as permanent life insurance, except that the cash value in a permanent policy is not independent of the life insurance (risk) component, but rather is a function of the policy’s design for unchanging premiums. On the other hand, the cash value component of universal life grows independently; and, when combined with the life insurance (risk) amount, both can be greater than the initial death benefit.

In many ways, universal life insurance and permanent life insurance can fill the same role. However, there are significant differences. The premiums in universal life are flexible and may or may not be sufficient depending upon cash value crediting rates. Also, depending upon the type of universal life insurance chosen, crediting rates may be tied to the insurance company's portfolio rate or a group of mutual funds. One that invests in mutual funds is called variable universal life (VUL). In addition, the VUL policy owner assumes the risk of what happens to the cash values and how they are invested. There are no guarantees in VUL considering the fact that cash values are invested in mutual funds. A VUL owner assumes the same investment risk as any other investor, such as a BTID investor. However, companies do offer a guaranteed fund for those who can’t stand the heat.

Even though we have only discussed three general classes of life insurance, all others are in some fashion a derivative of these. Once the life insurance advisor and client identify the model(s) that suits him, they can then look for any additional bells and whistles.

We have previously discussed some life insurance concepts and will revisit and expand on those as well as others. These concepts are usually standards or perceptions as to how one should buy life insurance. As with any concept, there are positive and negative features as well as assumptions that may or many not always be true or consistent.

For those advocates of buy term and invest the difference (BTID), the selling point is that one can purchase much more term life insurance for far less money than permanent life insurance and invest the difference. This difference, if invested properly, should accumulate to such an amount that it would surpass the cash values of any permanent plan as well as the original amount of life insurance purchased, thereby replacing one’s need for life insurance.

In theory, the concept sounds great but in practice it may fall short for a few reasons. There is no fault in the theory or application whatsoever, it’s just that there are forces and events that will usually throw a wrench in the works and mess up the intended results.

First, it makes the assumption that one’s life insurance needs will decline and or terminate in later years, thus arriving at the self-insured concept. For the majority, this is partially true except for the fact that there is always a cost of dying and life insurance will always be cheaper because of its fractional cost (opportunity costs).

Until the passage of the Economic Growth and Tax Relief Reconciliation Act of 2001, the estate tax laws have been slow in keeping up with the inflationary increases in asset growth and the numbers of estates subject to estate tax have continued to grow at an alarming rate. In these cases, a self-insured individual is the government’s best friend because everything is subject to estate tax. In other words, a self-insured individual is subject to more estate shrinkage than one that depends upon estate settlement via life insurance. The estate tax laws mitigate the desired effects of BTID. If designed properly, life insurance is the only tool that can create a tax-free sum to settle a decedent’s estate. For example, life insurance is typically exempt from federal taxation and proper trust planning, such as via irrevocable life insurance trusts, can make it exempt from federal estate tax.

Since the age at death may be beyond an insurance company’s willingness to renew term, permanent may be the only option. On the pro side of the BTID equation is the fact that most decedents will not have an estate tax issue.

Second, BTID assumes that one invests consistently and properly over his lifetime. When it comes to investing consistently over a long period of time, most folks are inconsistent at best. Somewhere in the future, when the budget gets tight, and it usually does, a breadwinner does not see the investing possibilities and futuristic nestegg with this so-called difference, he sees extra money to pay bills. Statistics indicate that going into debt, many times beyond one’s ability to pay, will siphon any extra money that was previously earmarked for something else, including investing. It is also very common for an investor to spend or even deplete investments done in the BTID fashion. Successful long-term investing that lasts for one’s lifetime is typically the one done through an employer-sponsored retirement plan; and, those utilizing the BTID concept do not usually invest in this fashion because the difference is usually invested through the agent’s broker-dealer.

Third, if one invests the difference in tax-qualified investments such as an employer-sponsored retirement plan, there are contribution limits; therefore, potentially making the future nest egg smaller than anticipated. Even if it is done through taxable investments, #2 above and taxability become issues.

Fourth, self-insured individuals are a rarity. The older one gets, the less likely he is to dump his life insurance plan - it just doesn’t feel right. He may not need it, but he won’t drop it. The realities of a long life and pending death are more prominent among seniors and life insurance has always been part of the process. Many seniors also want to leave something behind for their loved ones and they can’t do it with term that is not guaranteed renewable and has increasing premiums. Retirees have tight budgets and premium increases are not an option. Even though the amount of life insurance may not be very much, they will still want to keep some.

Some use a simple formula to determine the amount of life insurance needed, such as salary times an assumed number of years, say eight. Let's assume the breadwinner makes $50,000 a year; therefore, the amount of life insurance needed would be $400,000 (50,000 x 8). This technique is simple, nothing more nothing less, and does not take anything else into consideration, even any form of analysis to see if the amount is sufficient, excessive or lacking.

If one could find a way to continue his earnings after death, then all of his family’s financial needs would continue to be provided for. This concept assumes that a sufficient amount of life insurance could be bought; and, upon the breadwinner’s death, the death benefits could be invested at an assumed rate of growth, the earnings of which would replace the deceased breadwinner’s earnings. This would be a great concept if other components of dying (to be discussed in the next chapter) were considered as well as inflation and a very conservative investment rate. However, the concept is typically narrowly utilized as an income replacement tool only.

Let’s assume Joe Public had a net income of $40,000 per year and wants enough life insurance so that his surviving spouse would be able to invest it and earn the same. Even though taxes would be owed from the earnings, we’ll assume everything at a net yield. At an 8% growth assumption, he would need $500,000 (40,000 / .08) in life insurance. Since assumption rates are the key, here is what’s needed at other rates: $666,667 at 6%, $400,000 at 10% and $333,333 at 12%.

Even though most assumptions are rarely conservative enough, we’ll assume that 8% was chosen. Upon Joe’s death, Mrs. Public would take the $500,000 in proceeds and invest them. Of course, we’ll have to assume that other components of life insurance are nonexistent, that is, the funeral was free, the kids aren’t going to college, no estate taxes, no settlement costs, no attorney’s fees, and that death was sudden.

Notwithstanding the above additional assumptions, when one uses the income replacement method, the inflationary impact should be incorporated but many times is not. In our above example, what would happen if Mrs. Public did indeed yield 8% on her $500,000 investment? She would earn $40,000 every year, of course. However, what would happen if inflation averaged 3% for the subsequent 3 years? Her buying power would only be $38,800, $37,636 and $36,507, respectively, and so on. To compensate for shrinkage due to inflation, one must reduce the yield assumption by the inflation assumption. For example, if one assumed a yield of 8% and inflation of 3%, the actual assumption should be 5%, requiring $800,000 in life insurance.

Another fallacy is the consequences of an average yield, such as 8%, over a survivor’s lifetime. An average yield is based on the average of negative yielding years, low yielding years and high yielding years. The market is unpredictable and even though one’s investment may produce the anticipated average yield, the actual results will be different. If the survivor in this instance, Mrs. Public, just let the investment grow with earnings reinvested, there wouldn’t be any problem. However, this is not the case. She has invested in order to ‘replace’ a lost income and will be withdrawing $40,000 a year.

Since Mrs. Public will be investing, we’ll assume it will be in something correlated to the stock market; therefore, let’s use one of the most common barometers of stock market performance, the Standard and Poor’s 500 Index (S&P 500), as our benchmark. In this example, we’ll disregard the impact of inflation and assume Joe had $500,000 in life insurance. If Joe died at the end of 1999, Mrs. Public would invest at the beginning of 2000 and withdraw $40,000 (8%) every year to replace his lost income.

In 2000, the market lost 9.1%. Whether income is withdrawn at the beginning of the year, throughout the year, or at the end of the year, the results will be similar. In order to show the best results, we’ll assume withdrawals were made at the beginning of the year; therefore, at the end of 2000, the investment was worth $418,140. At the beginning of 2001, Mrs. Public makes her $40,000 withdrawal; however, it is now 9.57% of her total value. What happened to the 8% intended withdrawal amount?

In 2001, the market lost 11.80%. Her investment was worth $333,519 at year’s end. At the beginning of 2002, Mrs. Public withdraws her $40,000, which is now 11.99% of her total value.

In 2002, the market lost 22.12%. Her investment was worth $228,593 at year’s end. At the beginning of 2003, Mrs. Public withdraws her $40,000, which is now 17.5% of her total value.

In 2003, the market gained 28.67%. Her investment was worth $242,663 at year’s end. At the beginning of 2004, Mrs. Public withdraws her $40,000, which is now 16.48% of her total value.

Now, here’s the kicker. In order for Mrs. Public’s investment to keep from deteriorating, her yield will now have to average over 16% instead of the original assumption of 8%. What do the think the possibilities are of that happening? Only time would tell how long it would be before she would be broke.

Let’s digress a moment and conclude that an inflation rate of 3% was considered resulting in a 5% rate assumption. Instead of $500,000 in life insurance, Joe Public would have purchased $800,000 (40000 / .05). If Mrs. Public pursued the same investing route as indicated above, the effects would be the same – it would just take longer. However, at a 5% assumption, one would naturally invest accordingly, that is, in investments that were more conservative (yielding around 5%) and not subject to market fluctuations but rather having consistent returns. Let’s assume Mrs. Public followed this pattern of investing instead of the first pattern. At the beginning of 2000, she would withdraw $40,000. At year’s end, her investment would be worth $798,000. Following the same procedure and only withdrawing $40,000 a year, her year-end investment for 2001, 2002, and 2003 would be $795,900, $793,695, and $791,380, respectively.

As you can see, her investment still shrank, but slowly and with consistency. With such predictable shrinkage, survivors can make adjustments to overcome the shortage, such as a change in lifestyle to reduce expenses and/or additional supplemental income through employment.

In the above example, Mrs. Public’s investment would be zero in 66 years. However, even though we included an inflation adjustment to determine the amount of life insurance needed, we actually stopped there and did not include it in her income withdrawals, which remained at $40,000 annually. In order to be more realistic, what would be the effects of increasing withdrawals by the assumed 3% inflation rate? Well, considering only a ‘simple’ rate of 3%, her investment would be zero in 30 years. This is a big difference.

Now, let’s dissect the prior assumptions and see the results. We assumed an investment yield of 8% and an inflation rate of 3%, which would make an overall assumption of 5% resulting in a purchase of $800,000 in life insurance. What would be the results if Mrs. Public invested at 8% and made withdrawals that increased 3% annually? Of course, she would have to make investments that are subject to market fluctuations as in the very first example. Disregarding those fluctuations, here’s a short-term look at the possibilities. At the beginning of 2000, she would withdraw $40,000. At year’s end, her investment would be worth $820,800. Following the same procedure and withdrawing subsequent amounts including a ‘simple’ 3% inflationary increase, her year-end investment for 2001, 2002, and 2003 would be $841,968, $863,533, and $885,528, respectively.

By using only a ‘simple’ inflation assumption for survivor income annual increases, the investment will grow indefinitely. However, if one assumed a ‘compound’ inflation assumption, the investment will not grow indefinitely. By using the assumptions in the previous paragraph, the investment will be zero in 57 years. The key in all of these assumptions is to ensure that the money outlives the surviving spouse. A quick glance at a mortality table can show the minimum time frame that needs to be factored in.

Another concept is one that is a little more sensitive to a survivor's needs by first establishing 1) the amount of additional income needed multiplied by 2) the number of years needed. The advisor can calculate both factors by taking a data survey and performing a needs analysis. For example, by using a data survey one can calculate the family’s current cost of living and then discount out the things or expenses that will either be eliminated or lowered by virtue of the insured’s death. This remaining income amount will be lowered again by the amount of income sources that will continue after the insured’s death, such as the surviving spouse’s income. If the result is zero or less, then there is no need for any life insurance to provide for this need. However, if the result is greater than zero, one must estimate the number of years in which it will be needed. For example, let’s assume there are minor children involved with the youngest being fourteen years old. When the youngest child reaches eighteen, most advisors assume there will be an empty nest and the cost of child rearing will cease. Since the surviving spouse’s income will be sufficient without any children to support, additional income will only be needed for four years.

Many insurance professionals sell only permanent insurance to meet most, if not all, of the life insurance needs of the breadwinner, spouse and children. Some will go a different route by adding term riders to a permanent plan on the breadwinner to cover dependent children and/or the spouse. Term insurance is narrowly perceived as “temporary” or “renting” life insurance. This narrow view has its own set of fallacies. Those that promote this concept perceive life insurance as encompassing more required benefits than are actually needed by the policy owner. One must ask the question, “Why is the policy owner buying life insurance?” Is it to save for college, create a savings account, to meet a financial need upon death, etc.? How many bells and whistles or additional benefits does an insurance policy have to have in order to accomplish the policy owner’s objective?

Many life insurance needs are determinable as to the specific amount and time frame. For example, mortgage insurance is always equal to the outstanding mortgage and is needed until the mortgage is paid off. Life insurance for college planning should equal the projected college expense for the college of choice and terminates upon enrollment. Life insurance needed for income replacement terminates upon retirement. Life insurance needed to pay off specific debts equals the outstanding debt and terminates when the debt is paid off.

If life insurance is bought for a specific purpose, what is the logic in keeping it when that purpose no longer exists? Doing so would be as ridiculous as continuing to pay for car insurance on a car that was sold last month.

Since permanent life insurance is more expensive than term life insurance, why would a policy owner want to pay more for a need that was determinable as to the amount and time frame? He wouldn’t. However, the “permanent all the way” concept overlooks these distinctions.

Notwithstanding the above, permanent does play a critical role in one’s financial and estate planning. There are many situations in which a life insurance need exists until the insured’s death. For example, the most obvious is in the estate planning arena. For estate planning purposes, one buys life insurance to settle his estate. This won’t come about until death, which is when? Well, we won’t know until it happens. The untimeliness of death makes permanent a more sensible solution than any other form of life insurance.

Since many terms policies are limited as to age renewability, any need that goes beyond a term policy’s limit is best served with permanent.

Using permanent may best provide for any need for which the time needed is uncertain. For example, let’s say one has a handicapped child and his financial needs will last all of his life. Since he is totally dependent upon his parents, the likelihood of him being subject to a governmental or private alternative care system is great after the parents are deceased. Custodianship and quality of care become issues. Permanent life insurance on the parents specifically earmarked for this need may be the only solution.

Life insurance needs where a fixed income is an issue may only be satisfied with permanent. Of course, this assumes that the needed amount of life insurance can be purchased within the fixed income framework.

As previously mentioned, the decision on buying either term or permanent may be as simple as looking at whether the need is determinable as to the amount and time frame.

When one has group life insurance through his employer, should the group life be additional life insurance over and above his total life insurance needs or should it be used as an offset? Well, there should be several things the insurance professional should discuss with the prospective policy owner before such a decision is made. Typically, when an employer offers health insurance benefits, group term life insurance is part of the package; and, in many cases, the employer pays for it. In this instance, it is not a cost consideration and is usually not portable for the employee.

One should determine whether the group term “fits” into the policy owner’s objective and need. For example, if the employee only has permanent life insurance needs, then obviously group term would not be necessary. However, if the employer pays for it, then the point is relatively moot.

Is the group term portable? That is, can the employee continue to keep and pay for the policy if he terminates his employment? If not, then it should only be additional coverage unless it can be earmarked for some specific need that will terminate with the coverage.

An insured’s future insurability is a major consideration in using group term life insurance as an offset. If the group term is not portable, convertible or cannot be renewed to meet the policy owner’s time frame, then his ability to replace the amount with personal life insurance is a futuristic crapshoot.

Even though group term life insurance is a cost effective way of purchasing life insurance, there are limitations, which usually max out at between 1-5 times the employee’s salary depending upon his position.

Pension Max, as it is called, deals with maximizing a retiree’s pension plan payout. Generally speaking, all retirement plans have multiple ways in which a retiree can receive an income or payout. Also, retirees are always concerned about ensuring that their retirement benefits will continue to be paid to survivors, especially surviving spouses.

The highest payout a retiree can receive is the Single Life Option, which basically pays the retiree as long as he’s alive. Once he dies, whether it is one year or thirty years later, the payments stop. Any other option has a cost attached, which results in a reduced benefit. For example, let’s assume Joe Public has a pension plan that will provide $1,500 a month for life under the Single Life Option. However, Joe is married and under this option Mrs. Public will receive nothing after Joe dies. This doesn’t set well with Joe so he picks the 50% Joint Survivor Option. He will now receive $1,200 a month until he dies, then Mrs. Public will receive $600 a month until she dies. This guarantee costs Joe $300 a month while living and $900 a month thereafter.

If Joe uses the pension max system (in its purest sense), he will take the single life option and buy enough life insurance with the $300 difference between the two options to provide Mrs. Public $1,200 - $1,500 a month for her lifetime. The first part of using this system is a no-brainer: pick the single life option. The second part of this system is tougher: how much and what kind of life insurance will do the trick. There are many factors which one must take into consideration to make this a successful strategy. The beginning stage is Joe’s current age and the expected mortality of Mrs. Public. If both of them are 55 and Mrs. Public’s expected mortality is age 83, then the time frame to consider is 28 years, assuming Joe died in the current year. If we assume $1,500 monthly income for Mrs. Public, an investment rate of 8% and cost of living (inflation) increases of 3% simple, then Joe would need to purchase $271,735 (the present value amount) in life insurance with his $300 a month. Whether or not he can buy that amount for $300 a month remains to be seen. The longer Joe lives, this life insurance slowly transforms into either an additional retirement fund or estate sum for surviving heirs.

One of the major drawbacks of pension maximization is that it is used as a sales tool for large life insurance sales without considering the bigger picture of one’s total life insurance needs. For example, let’s assume Mrs. Public’s survivor income, excluding Joe’s retirement plan, is more than sufficient. Can one still justify selling a huge amount of life insurance?

The self-insured concept is uncommon but it does exist. Various organizations have tried this concept or at least have moved toward this concept and continually find that it is not as cost-effective as the risk-sharing concept of insurance. From an individual perspective, does being self-insured make sense? Well, it really depends on how one perceives it - from a narrowly defined or broadly defined perspective.

How can we describe a narrowly defined perspective? How about this: life insurance fulfills a financial need that becomes unfulfilled through death. If this is the case, then there are many folks who do not have a life insurance need because they have enough resources to take care of those needs. For example, if one has a small estate, no dependents and no debts, then the only thing left, generally speaking, is to pay for a funeral. This is the financial scenario for many baby boomers and retirees. If there are enough assets to do the job, what need is there for life insurance?

Now let’s look at the broadly defined perspective. Life insurance is fractional cost and risk sharing, which beats any other payment scheme one hundred percent of the time. Let’s assume the cost of dying is $25,000. Is it more cost effective to pay this expense by using a $25,000 asset such as a certificate of deposit or to spend about one percent per year on life insurance and let someone else pay the $25,000? You be the judge.

This is probably the most comprehensive concept. It is one that is used to derive an assumed rate, such as was used in the income replacement methodology previously discussed. There are some assumptions that drive this concept thereby making it subject to the same problems in any analysis in that reality will diverge from the assumptions or expectations. In terms of life insurance, to capitalize an assumed rate results in an amount of life insurance that will “supposedly” provide a perpetual income stream. The impetus behind a capitalization rate is to start with a conservative interest rate assumption reduced by a realistic inflation assumption. This is divided into the needed survivor income stream to determine the amount of life insurance to be purchased.

Previously, we used an 8% interest rate assumption and 3% inflation assumption. We have already shown that in order for one to yield 8%, some or all of his investment will have to be placed in at-risk investments subjecting it to possible negative consequences. The same problems exist if inflation is different than expected. A revisit of the double-digit inflation rates of the 80s will have the same negative consequences. On the other side of the coin, the lower rate one chooses, more life insurance will need to be purchased. Income constraints can certainly make this a juggling act.

There are fallacies with any methodology used in determining one’s life insurance needs. Considering the consequences, it only stands to reason that one would seriously take them into consideration and the trade-offs. Ultimately, the key in determining enough life insurance is to ensure all postmortem needs are provided for and that income replacement survives the survivors.

For personal planning, there are five major components that determine the amount of life insurance one should have. They are: 1) burial costs and last expenses, 2) debt payoff, 3) survivorship income, 4) college funding, and 5) estate taxes and settlement costs. Not all of these components are applicable to everyone. For example, couples with no or grown children have no college funding needs; however, it may be a need for grandparents. Estate taxes are not a concern for those with smaller estates. The financial advisor can help one determine the applicable component and calculate each.

To get an idea of burial costs, one should call a local funeral home and consult with a representative about costs which will include service costs, flowers, casket, vault, marker, opening and closing, burial lot, etc.

Last expenses can include many things. Some are out of pocket expenses such as the coinsurance and deductibles from one’s health insurance. Many times death is preceded by an illness, sometimes prolonged, with extensive medical treatment. Depending upon one’s illness, there may be extensive travel to special clinics or hospitals. During these times, the ill family member and accompanying adult may be off work, not earning a paycheck. There is also the cost of eating out, motel expense and long distance phone bills. For families with dependent children, there can be additional costs for childcare. With the host of possibilities, survivors can experience last expenses up to $25,000 or more.

The worse time to plan for the inevitable is after it happens. It is vital for one to preplan in this area so that bereaved survivors won't make costly financial decisions. For example, Client A decides to make funeral arrangements (called pre-need funeral planning) for himself and decides with forethought and sound mind upon a simple casket, simple vault, simple marker and simple funeral. Client B does not plan and upon his death, bereaved survivors, in an attempt to keep things simple but not an appearance of looking cheap, decide upon a middle of the road approach. After all, their deceased loved one deserves better than cheap. As a result, the out-of-pocket costs for Client B’s survivors will probably be much more than Client A. How often will one spend more money on his own funeral while living than what survivors will spend upon his death? Never!

This is one that seems to complicate the "how much" decision but in reality it is one of the simplest to determine. Here's the dilemma. Does one buy enough life insurance to 1) pay off debt or 2) have enough to make the payments on the debt? The answer is always the same: one must have enough life insurance to pay off the debt.

Let's take a simple example, a home mortgage, because all debts work the same way and this line of reasoning applies. A $250,000 30-year mortgage with a rate of 8% requires a mortgage payment of $1,822.26. After ten years, the homeowner decides to buy some mortgage life insurance to cover the balance in case of premature death. If he chose the payoff route, the amount of life insurance needed would equal the current payoff amount of $221,534. If, on the other hand, he chose the payment route, we would take a different approach. The annual mortgage payment is $21,867.12 (1822.26 x 12); therefore, he would only need to know the required investment yield that would produce $21,867.12 annually until the mortgage was paid off, which is 9.87% (21867.12 / 221534). Anything less would require him to dip into the principal. How many times and to what extent can one dip into the principal until it runs out? Obviously, since the required yield is too high, he would need to purchase more life insurance.

Well, we already know there are consequences and trade-offs with any interest assumption. With the host of negative possibilities inherent in depending upon such a yield for the remaining 20 years of a mortgage, this would not be the preferred choice. Ultimately, this is really a no-brainer decision – choose an amount equal to the debt.

This can come from numerous sources such as social security, investment income, the salary of the surviving spouse, or pension income from a deceased spouse. Assuming debts are necessarily paid off, a survivor may need additional income in order to maintain the same standard of living.

Basically, when one determines, through a cash flow analysis, how much a surviving spouse’s income needs will be, he can deduct all available income sources to arrive at the deficient amount. From here he can calculate the amount of life insurance needed to fill the gap by using one of the methods discussed in the previous chapter.

Chances are that scholarships will be minimal or not be available to most clientele; therefore, alternative funding must take place, if at all. Some states offer tuition programs that originated from the Internal Revenue Code, Section 529 – Qualified Tuition Programs and are popularly known as Section 529 Plans. Other than 529, Hope, UGMAs, UTMAs, and some of the other legislative acronyms, there are two alternative ways of providing for college. One is lump sum and the other is pay as you go. For lump sum, one must either have an investable sum or purchase an equivalent amount of life insurance in case of premature death of the breadwinner, which will be the focus of our discussion.

To calculate the proper sum (life insurance), one must determine the present value of a child’s future college expense and invest accordingly. Let's consider the college expense for a newborn. This means tuition will be needed 18, 19, 20 and 21 years hence. Since most parents and grandparents would want to have everything in place by the time a child enters college, let's also assume the total funding package will need to be available at age 18. Otherwise, one would still be paying for college expenses during the child’s sophomore, junior and senior years. One can anticipate that once a child enters college, expenses will continue to rise each year and he should either assume an average increase for all four years or he can discount each subsequent year to arrive at an amount. Either way, the college funding amount will be needed at the child’s age 18 to provide for all four years.

College expense has its own inflation rate and has historically been twice to three times the CPI. It needs to be mentioned here that most parents and grandparents overlook the trend in rising college costs and are overwhelmed as the years pass by. Some financial magazines periodically report this information, so it is available. The college inflation factor is one that must not be overlooked. For our calculation, we'll assume 8%.

The next thing one must do is to select a college and contact the student services department to get an idea of expenses (room and board, tuition, books and fees). The easiest way is to get on the internet and find out anything about any college. Let's assume a local college at a cost of $7,500 per year. By using Table A-1, Future Value of $1 at 8%, we find the following factors, 3.996, 4.3157, 4.661 and 5.0985 (interpolated), which are multiplied by $7,500 to determine our future costs: freshman year ($29,970), sophomore year ($32,368), junior year ($34,958) and senior year ($38,239).

As mentioned before, we can discount each sum to arrive at a total amount needed at the start of the freshman year, but to keep things simple let's just add all four; therefore, we'll need $135,535 when our newborn reaches age 18. Now we need to assume a discount rate that is the rate of return we expect to receive from investing. One must consider the client's investment experience and risk tolerance. If one is to err, let’s err on the safe side and only assume a 5% yield. By using Table A-2, Present Value of $1, we find the factor of 0.4155 at the intersection of 5(r) and 18(t). In summary, the client needs to invest a lump sum or, as in this discussion, buy life insurance in the amount of $56,315 (135,535 x 0.4155).

As previously mentioned, estate settlement costs may come in many forms depending upon the complexity of the estate and planning measures already taken. These costs can be legal fees, bonds, appraisal fees, business valuation fees, broker and auctioneer fees, court costs and state inheritance taxes. The actual amount of each will not be known until death. In determining estate taxes due, one can use the following formula:

Gross Estate		$ __________
- (a) Marital Deduction	$ __________
- (b) Charitable Bequests	$ __________
- (c) Expenses and Debt	$ __________
= Taxable Estate		$ __________
+ (d) Adjusted Taxable Gifts	$ __________
= Estate Tax Base		$ __________
Tentative Estate Tax		$ __________
- (e) Prior Gift Taxes	$ __________
- (f) Unified Credit	$ __________
- (g) State Death Tax Credit	$ __________
- (h) Prior Transfers Credit	$ __________
- (i) Foreign Death Tax Credit	$ __________
= Estate Tax Due		$ __________

To find an elaboration of the items mentioned above, one can search the appropriate section of the Internal Revenue Code on the Internet at www4.law.cornell.edu/uscode. For example, Gross Estate is defined at 26 U.S.C. 2031, that is, section 2031 of the Internal Revenue Code.

Once the gross value of a decedent's estate has been calculated, the advisor can proceed to make appropriate adjustments to ultimately arrive at the Estate Tax Base, which is used to calculate the Tentative Estate Tax due.

(a) As mentioned above, the marital deduction (26 U.S.C. 2056) can be unlimited and if fully used it can make the rest of the formula a moot point. However, this only applies to the first spouse to die. Proper planning, of course, may dictate otherwise and the impact upon the second spouse's death will come into play. This component is not applicable to single individuals.

(b) Charitable bequest deductions (26 U.S.C. 2055) against the gross estate are contributions made to any qualified charitable, public, governmental, religious, scientific, literary or educational organization. Unlike the contribution percentage limitations applicable to federal income taxes, these deductions have no limitations when considering estate taxes. For example, one could leave an amount to his heirs equal to the exemption equivalent and give the rest, no matter how much, to charity and have no federal estate tax liability.

(c) There are other expenses that are deductible against the gross estate. These basically fall under estate settlement costs and debts (26 U.S.C 2053 and 2054). Estate settlement costs were previously defined and are limited in scope as to reasonableness and necessity. Some are even limited according to state statute. If the estate suffers from any casualty during the settlement period, these losses are also deductible.

(d) Once the Taxable Estate has been calculated, adjusted taxable gifts are added back to arrive at the Estate Tax Base. To calculate adjusted taxable gifts, one must first determine the amount of taxable gifts made after 1976.

Since gifts of $10,000 or less per year per person are not taxable, this item would mean gifts in excess of that amount. New legislation (26 U.S.C. 2503) has incorporated an inflation adjustment to the $10,000 figure. In summary, it says that the inflation adjustment (CPI) for any given year is the percentage increase of the prior calendar year over 1997. There is also a caveat that says increases must be in $1,000 increments. The Consumer Price Index (CPI) can be found on the U.S. Department of Labor’s website at http://www.bls.gov/cpi. In order to calculate the proper tax-free gift for 2004, we would have to find the percentage increase of 2003 over 1997. Their factors were 184.0 and 160.5, respectively, which is a 14.642% increase. This would make the amount $11,464, rounded down to $11,000.

Taxable gifts are reduced by gifts included in the decedent's estate (gifts that fall within the 3-year rule) and prior exclusions and deductions taken for gift tax purposes. Once the Estate Tax Base is determined, one can go to Table A-3, Estate & Gift Tax Calculations, to figure the Tentative Estate Tax due. For example, let’s assume one’s Estate Tax Base is $2 million in 2002; therefore, his Tentative Estate Tax due is $780,800.

(e) Before any tax credits are applied, one must first deduct any gift taxes actually paid on post-1976 gifts. This relates to those gifts mentioned above that exceeded the $11,000 limitation. This also assumes that one did not use part of his unified credit to forego paying any gift taxes due.

(f) The unified estate tax credit (26 U.S.C 2010) is the first tax credit and can be found in Table A-3. This is a once in a lifetime credit per person and may be used prior to death to offset gifts taxes due. Any remaining amount at time of death will be the applicable amount. For 2002, the unified estate tax credit is $345,800.

(g) A state death tax credit (26 U.S.C. 2011) is allowed for those states that have death taxes. If a state does not have such a tax, then the amount remains as part of the overall federal estate tax due. The credit applies to adjusted taxable estates in excess of $40,000 and can be calculated by using the State Death Tax Credit. The adjusted taxable estate mentioned in the table is the Taxable Estate minus $60,000. We had previously assumed an Estate Tax Base of $2 million. Since there is an unlikely event that there will be any adjusted taxable gifts, one can also assume the Taxable Estate will be $2 million as well. For purposes of the State Death Tax Credit, this results in an adjusted taxable estate of $1,940,000 (2 million – 60,000) with a credit of $99,600.

(h) Many estates consist of an inheritance called prior transfers (26 U.S.C. 2013). For example, John Sr. (the transferor) died a few years ago and bequeathed one-half of his $1 million estate to John Jr. who died last week with an estate valued at $2 million. John Sr.'s bequest to John Jr. was a prior transfer of which estate taxes of $300,000 were already paid. In order to prevent double taxation, John Jr.'s estate gets a credit for all or part of the taxes previously paid on John Sr.'s estate. This is referred to as a prior transfer credit. This credit is available if the current decedent dies within 10 years after or 2 years prior to the transferor. The credit is calculated by multiplying the tax paid on the transferor's estate ($300,000) by the ratio of (1) the transferred property's value ($500,000) and (2) the transferor's taxable estate ($1 million). John Jr.'s estate will receive a credit of $150,000 (300,000 * (500,000/1,000,000)). This full credit is allowed if the current decedent, John Jr., died within two years before or after the transferor, John Sr. If not, there will be a reduction as follows:

(i) Foreign death tax credit (26 U.S.C. 2014) is limited to the smaller of (1) the portion of foreign death taxes paid attributed to property included in one's gross estate but located in a foreign country; or (2) the federal estate tax, after credits, attributed to property included in one's gross estate but located in a foreign country.

In summarizing this component, we quickly see that it can be onerous. However, most who do have large estates already have tax professionals they can consult with and can easily make a determination.

Since life insurance can be one of the largest components of one's estate, then taxation of that life insurance becomes an important issue. For federal income tax purposes, life insurance is generally tax-free to the beneficiary, except for instances of ‘transfer for value’ and those that violate DEFRA guidelines (26 U.S.C. 101). The inclusion or exclusion of life insurance in one's estate determines its federal estate taxation. By default, life insurance proceeds payable to one's estate, the estate's executor or any individual or entity responsible for the estate's obligations will cause the value of the life insurance proceeds to be included in the gross estate. In essence, when proceeds benefit the estate either directly or indirectly they are included in the gross estate.

If a decedent possesses any "incidents of ownership," then 100% of the proceeds are included in his gross estate. In community property states for policies that are considered community property, only 50% of policy proceeds are included in one's gross estate. The incidents of ownership rule applies when the deceased possessed any of the following rights:

- to change any beneficiary
- to assign policy proceeds
- to borrow values or use as collateral
- to surrender the policy
- to cancel the policy
- to elect or change settlement options
- to convert from group to individual
- to exercise reversionary interest
- to exercise any contractual right

One may also give away or assign policy benefits to others, but if he dies within 3 years the policy proceeds will be included in his gross estate.

What other sums can be available in considering one’s total life insurance needs? Even though this discussion may not seem that important to some, it is good for the insurance professional to be aware of these offsets and discuss them with potential clients. There can be a lot at stake.

When considering offsets, it is always a good idea to review the prospective client’s present coverage. Just as it is prudent for investors to reevaluate investments and investment objectives to ensure compliance with current needs and risk tolerances, the same applies to insurance. Many people hold policies that were bought for them as youngsters and are subject to very old mortality tables. When compared to newer forms of life insurance, some older policies may be inferior to such things as mortality costs, policy fee structure, crediting rates and profit sharing between the policy owner and insurer. The belief that a policy is good forever really doesn’t hold water.

We’ll only elaborate on the specific issues of personal coverage that may be considered as an offset other than the coverage itself. For example, when determining the amount of life insurance needed on the breadwinner, take into consideration some items on the other spouse’s life insurance, such as cash values and dividends. In many instances, these items have already been used for ‘living’ benefits whereby the monies were borrowed and used for current needs such as paying for bills during times of a cash flow crisis. How does the death of a breadwinner differ from any other current need or cash flow crisis other than magnitude?

Preferably, cash values and dividends on another family member’s life insurance should not be considered as an offset unless one could not afford the total amount of life insurance needed. These values could, however, come into play upon the death of any family member to make up for any cash deficit needed by the survivors.

If one considers retirement plans as an offset, there are consequences that must be discussed. If plans are tax-qualified or tax-deferred, then there may be a tremendous tax cost in liquidating these plans. Non-qualified plans don’t have the same tax impact but they do affect the post-retirement needs of a surviving spouse.

For planning purposes, one should continue to earmark retirement funds toward retirement and use life insurance only to meet survivor income needs before retirement. The main reason for this is that there is only one two-pronged conclusion in life: retirement is a costly inevitability unless one dies first. In that regard, if one uses part of his retirement nestegg to offset his life insurance needs, then the consequences can be costly for his survivors.

For example, Joe Public and his wife are age 49 and he needs $300,000 in life insurance and has $200,000 in his 401(k). Joe decides to use his 401(k) as an offset to his life insurance needs so he only buys $100,000 in life insurance. The next year, at age 50, Joe dies. With other income offsets, Mrs. Public still needs $25,000 in annual survivor income to maintain her standard of living until she can draw social security at age 65. She has the $200,000 in Joe’s 401(k) and $100,000 in life insurance for a total of $300,000. However, assuming previously used assumptions, this amount will decline to zero at age 65 and she will only be left with her social security.

Joe should have purchased $300,000 in life insurance and left his retirement plan intact. The life insurance would have provided for her income needs until she reached age 65. Assuming Mrs. Public would retire at age 65, the 401(k) would have grown to $415,000, which would provide a nice income supplement to her social security. Instead, because of Joe’s wrong choices, she will only end up with a social security check.

What about those instances where retirement income is either insufficient or totally lacking? Well, life insurance can also be bought to fill this gap; however, it can only take the place of sound retirement planning if the insured breadwinner dies.

A savings plan is typically earmarked for two purposes: specific items or just to create a sum for whatever. Savings can usually bring some consistency in the budgeting and bills paying process. However, the death of a breadwinner or spouse usually interrupts the intended purpose of a savings plan; therefore, including it as an offset would probably not create any financial crisis especially since most savings plans are small and will have an insignificant impact on any survivor income needs.

Personal preference is usually what determines if a savings plan will be used as an offset to life insurance. From a psychological perspective, many people have a hard time saving and just its mere presence is sometimes regarded as sacred and is to be left alone.

“You can’t take it with you” is just as true today as when Adam was created. Someone is going to inherit another’s wealth. However, statistics indicate that the wealth that most of us inherit will be like getting a tax refund – we get it and spend it. The odds of getting an inheritance, the size that rivals the lottery, are as remote as winning the lottery. Nevertheless, inheritance planning exists and is a viable part of many a financial advisor’s practice.

So, how does life insurance play in planning for an inheritance? Well, it depends. Is the relative/donor still living or deceased? If he is still living, then that poses a problem – never count your chickens before your eggs hatch. An anticipated inheritance will always take longer and be less than one thinks. In addition, to depend upon such an event is the same as waiting for money to grow on trees. Proper planning takes time with the resources one currently has available. Depending upon anything else is ludicrous. It’s like spending money before the anticipated raise or buying Christmas gifts based on the year-end bonus you think you’ll get.

When one gets an inheritance, he should perceive it as any acquired amount and plan accordingly. Generally speaking, receiving an inheritance upon the death of a relative is the same as being the beneficiary of the life insurance on the same individual. As with any sudden financial change, one should pause for a time to allow the newness to settle.

An inheritance should cause one to reevaluate his life insurance needs from two perspectives. The first is that prior needs that were only met through the purchase of life insurance may now be met with the inheritance; therefore, the amount of life insurance earmarked for that purpose is now unnecessary. The second is that the amount of inheritance may pose a federal estate tax problem, which can be handled through the purchase of life insurance.

Social Security. The current Social Security death benefit is $255. (www.ssa.gov). All other social security benefits will offset the need for life insurance. If there are dependent children, there is an income benefit that is payable until the child reaches the age of 18 unless disabled, generally speaking. Social security income reduces survivor income needs as well as retirement income needs. As long as social security is politically correct, one can depend upon it and its future values. However, it is also a fiscal hot potato for the government especially with the projected negative impact from the baby boomer generation and no real solution on the horizon.

Surviving Spouse Employment. Any employment income of the surviving spouse should always be used to offset survivor income needs. Traditional (one work, one stay home) families have been on the downswing for years, so many families are dependent upon two incomes. Even in those situations where the family was dependent upon one income, it is highly unlikely the surviving spouse can go out and get a equal paying job as the deceased spouse.

Many surviving spouses will feel a need to get a job, part-time or full-time, and be active after a spouse dies. When discussing this issue, the insurance professional needs to be conservative in his estimations of surviving spousal income not yet realized.

Royalties. Royalties don’t terminate upon the beneficiary’s demise and should always be used as an offset to survivor income needs. However, some royalties deplete over the years; therefore, they should be discounted.

Retirement Income. It is not that unusual for military personnel to put in their twenty+ years, receive their military retirement and then work in the private sector. Many work in the Civil Service and follow the same path. Few have prior corporate employment and yet receive a so-called retirement benefit long before the age of retirement, even while continuing employment in the private or corporate sector. All of these retirement plans typically have reduced income benefits for survivors, which should be used to offset survivor income needs.

In every home, there are fixed expenses that terminate upon someone’s death. The most obvious one is the monthly premium for the insured’s life insurance. Upon death, this expense will not be included in the fixed expenses in determining survivor income needs. Other obvious fixed expenses that will cease are the insured’s: health insurance cost, car insurance cost, personal cell phone cost, car payment on insured’s car (assuming it would be sold).

If the terminating fixed costs are easily ascertained, there is really no reason to include them as a continuing fixed expense for survivors. By omitting them, there will be less need and cost for funding the proper amount of life insurance.

From the prior chapters, one can quickly conclude that the complexity of figuring one’s life insurance needs can be quite extensive. However, as with all complex things, there are usually easy and simple methodologies that bypass much of the burdensome information gathering, analysis and number crunching. It really depends on whethe