The wealthy earn more money, amass greater wealth, and frequently pay a lot of taxes. An outgrowth of having great wealth is a desire to keep as much hard earned money as possible.

Life insurance is a popular way for the wealthy to maximize their after-tax affluence and have more money to pass on to heirs. Here's how and why insurance helps. (For related reading, see: Life vs. Health Insurance: Which to Buy.)

Tax Laws Favor Insurance

Tax law grants life insurance premiums and proceeds tax benefits and allows the rich a way to protect assets.

The proceeds of life insurance are tax-free to the beneficiary. Wealthy people don't want their deaths to be financial travesties for heirs, so the death benefit is a big component of any life insurance strategy. But there are additional advantages to life insurance.

If the policy owner has an estate that is worth less than $5.45 million for an individual and $10.9 million for a couple, the estate is exempt from federal estate tax. So what about the people with estates worth more than $10.9 million? The proceeds of a large life insurance policy can be used by the heirs to pay a tax bill for those wealthy individuals whose estate surpasses the estate tax exempt threshold.

Insurance premiums, also, won’t be subject to estate taxes. For example, if a wealthy individual spends $500,000 for a $2 million life insurance policy, that initial premium payment comes out of the estate and won’t be taxed. To look at the insurance premium another way, the after-tax value of the $500,000 is $300,000, thus for $200,000 ($500,000 premium amount - $300,000 estate tax), the family receives a $2 million guaranteed life insurance payout. That's a guaranteed return on the premium payment. (For related reading, see: How Much Life Insurance Should You Carry?)

Biz Owners Should Definitely Have It

If an entrepreneur co-owns a business, life insurance can fund a buy/sell agreement in the event of an owner's sudden death. A family business will benefit from a key man insurance policy. This is insurance on the main person in a small business, usually the owner, founder, or key employees. This policy protects the firm from going under in the event that key personnel pass on before a replacement is in place.

An added benefit for these types of insurance policies are that the premiums are usually deductible as a business expense.

Life Insurance as an Asset

Life insurance is more than a death benefit. Depending upon the type of insurance, it may have a cash or intrinsic value. Thus, when the insurance is no longer needed, it can be sold as a life settlement.

Whole life insurance, properly structured, can offer steady tax-free dividends. Although not guaranteed, many insurance companies have been around for up to a century. The cash value in the policy also builds up and can be used as your own private bank for a variety of income producing activities.

Finally, with whole life insurance, your death benefit is guaranteed regardless of your future health. This is important long term security for the policy owner’s family and heirs. (For more, see: Exploring Advanced Insurance Contract Fundamentals.)

Life Insurance Strategies

There are a variety of insurance scenarios to choose; the right one may depend on, say, how your current retirement fund gets taxed. Consider these examples:

1. Retirement Plan 401(k) plan or individual retirement account (IRA) Funds Life Insurance Strategy

Wealthy individuals’ retirement plan funds are taxed twice — first as income and next, with an estate tax. James has $900,000 in his IRA. To avoid losing a large percent of his IRA to Uncle Sam upon his death, James buys a second-to-die insurance policy with his $900,000. Upon James’ death, his wife receives the $3 million tax-free benefit.

2. Transfer Current Life Insurance with Cash Surrender Value Policy to Increase Death Benefit

Kevin had a 10 year-old second-to-die insurance policy worth $850,000 with a death benefit of $1.53 million. His advisor recommended he do a tax-free insurance policy exchange. The new policy had an increased death benefit of $3.48 million and there were no out of pocket charges.

3. The Two-Step Annuity Tactic

Sarah buys an immediate joint life annuity for $1 million, which pays $43,843 annually as long as Sarah and her husband Sean are alive. Next, Sarah uses the annual $43,843 payout to fund a $5.68 million second-to-die policy. In essence, Sarah converted $600,000, the after-tax value of the initial $1 million, into $5.68 million. Finally, both the annuity and death benefits are guaranteed.

The Bottom Line

A financial advisor is important when it comes to researching smart insurance strategies for wealthy clients. These folks have an enviable problem — managing, preserving and growing wealth. Properly structured life insurance can help them with all these goals. (For related reading, see: Who Should Be Your Life Insurance Beneficiary?)

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