Life Insurance

Life insurance is a contract under which an insurer agrees to pay a stated amount, the death benefit, to one or more beneficiaries when the person whose life is insured dies, in return for premiums paid while the policy is in force. Its most common job is to replace the income or cover the debts and expenses that a death would leave behind.

Three roles define every policy. The owner buys and controls it, names the beneficiary and pays the premiums. The insured is the person whose death triggers the payment. The beneficiary receives the money. They are often the same household and sometimes different people or a trust, and the owner must have an insurable interest in the insured's life when the policy is issued. For federal tax purposes the Internal Revenue Code adds a technical definition: a "life insurance contract" is "any contract which is a life insurance contract under the applicable law, but only if" it meets the cash value accumulation test or the guideline premium and cash value corridor tests of section 7702.

Two families. Term life insurance covers a fixed period, such as 10, 20 or 30 years, and pays only if the insured dies within it. Permanent life insurance is designed to stay in force for life and accumulates a cash value the owner can borrow against or surrender. Whole life, universal life, indexed universal life and variable universal life are its main forms, and they differ in what is guaranteed and who bears the investment risk. Each has its own page.

Where people get it. An individual policy is bought from an insurer and belongs to its owner. Group life insurance through an employer is a workplace benefit governed by the plan, and it generally ends when the job does.

The tax treatment. Section 101(a)(1) of the Internal Revenue Code provides that "gross income does not include amounts received (whether in a single sum or otherwise) under a life insurance contract, if such amounts are paid by reason of the death of the insured." The main exception is a sale of the policy: after a transfer "for a valuable consideration," the exclusion is limited to what the buyer paid for the policy plus the premiums paid afterward. The statute exempts some transfers, such as one to the insured, a partner of the insured or a corporation in which the insured is a shareholder or officer, but a sale to an outside investor gets no exception. Section 7702's tests matter because a contract that fails them is not treated as life insurance for tax purposes, and a policy that passes them but is funded too quickly can become a modified endowment contract, whose withdrawals and loans are taxed less favorably. Death benefits can also be included in the insured's gross estate for estate tax, when the insured held any incident of ownership in the policy at death or the proceeds are payable to the estate, which is why some families hold policies in an irrevocable life insurance trust.

How much and for how long. Needs analysis estimates what the survivors would need, and human life value estimates the earnings a death would remove. Neither depends on the policy type, which is the second decision.

1. The owner applies, naming the insured, the coverage amount and the beneficiaries.
2. The insurer underwrites, pricing the policy on the insured's age, health and habits, or declining it.
3. Premiums keep the policy in force. Missing them can make the policy lapse after a grace period, or, on a permanent policy, draw down its cash value.
4. At the insured's death, the beneficiary files a claim with a death certificate, and the insurer pays the death benefit, less any outstanding policy loans.

For example: Odette owns a $250,000 policy on her own life and sells it to an investor for $20,000. The investor pays $15,000 of further premiums before she dies. Because the policy was transferred for valuable consideration, the investor can exclude only $20,000 + $15,000 = $35,000 of the death benefit; the other $250,000 - $35,000 = $215,000 is included in the investor's gross income. Had Odette kept the policy, her beneficiary would generally have excluded the full $250,000.

Pros

• It turns small regular payments into a large sum at the moment a family loses an earner.
• The death benefit is generally free of federal income tax and is paid directly to the named beneficiaries.
• Term coverage can be inexpensive for young, healthy insureds.

Cons

• Coverage depends on health at application, so people who wait can pay more or be declined.
• Permanent policies cost much more than term for the same death benefit, and their non-guaranteed projections may not be met.
• A lapsed or surrendered policy pays nothing, and an outstanding policy loan reduces what the beneficiary receives.