10 Circumstances When You Should Use Single Premium Life Insurance

In general, some type of life insurance is indicated when a person needs or wants to provide an immediate estate upon his or her death. This need or desire typically stems from one or more of the reasons discussed in detail in. Single premium life insurance may be appropriate for any of these purposes, but is more appropriate for some and is uniquely suited for other purposes. Single premium life, in contrast with term insurance, which provides the highest possible death benefit for the lowest initial premium outlay, provides the lowest initial death benefit for the level of premium paid. Consequently, the single most important reason for buying a single premium policy is the desire for maximum tax-deferred or tax-free investment in conjunction with life insurance. If the investment objective is not present, or at least, not highly important, some other form of insurance typically will be more suitable.

If the need for at least some insurance is not present, typically annuities or other investments are more suitable. However, if both life insurance and tax-deferred investment objectives are present, single premium life provides a unique combination of attractive features.

Because all new single premium policies are likely to be MECs, the prospective buyers must fully consider the limitations applying to MECs (discussed below under “Tax Implications”) when assessing whether a single premium policy or some other form of life insurance is most appropriate for the intended use.

Single premium life insurance in particular is indicated in the following circumstances:

  1. When the objective is to entirely prefund a specified minimum death benefit for a specific purpose, such as a charitable bequest or a legacy for children – The single premium policy permits the policyowner to assure the bequest with no further concern about possible lapse due to failure to pay premiums. Further, the premium payment is determined based on competitive tax-free rates of return. In addition, in most cases if the investment and mortality experience of the company is favorable, the face value of coverage will increase in order to continue to satisfy the IRC Section 7702 tests to qualify as life insurance.
  2. As a vehicle for gifts – For example, a grandparent can give up to $14,000 (the gift tax annual exclusion in 2015, as indexed) a year gift tax free to a child as custodian for a grandchild. The parent can then use the cash to purchase a single premium policy with a $14,000 premium on the life of the grandparent for the grandchild’s benefit. The $14,000 is removed from the estate of the grandparent without federal gift tax cost, and can provide an income and estate tax free transfer to the child greatly in excess of the original $14,000.
  3. In exchange for ordinary whole life policies at ­retirement – Under the Section 1035 exchange provisions, a policyowner may exchange an existing ordinary whole life policy that has substantial cash values and continuing premium payments for a single premium policy. The exchange would eliminate future premium payments, provide a relatively high tax-free rate of earnings on the underlying cash values, and may provide a higher death benefit. Policyowners should compare such possible exchanges to the reduced amount paid-up nonforfeiture option available with all cash value policies.
  4. As a substitute for tax-free municipal bonds and other investments so as to reduce exposure to income tax on Social Security benefits – Both single and married persons with adjusted gross incomes exceeding certain levels are subject to income tax on up to 85 percent of their Social Security benefits. Taxable income from certificates of deposit, money market funds, and other taxable investments as well as what is otherwise tax-free municipal bond interest is included in determining the amount of Social Security benefits subject to income tax. The interest earned on cash values of life insurance policies is not included. Therefore, taxpayers could convert investment funds into a single premium policy, thereby reducing taxable income and the taxpayer’s tax base, and eliminating the tax on Social Security benefits.
  5. As an emergency fund reserve – Although proceeds from MEC policy loans are taxable to the extent attributable to earnings in the policy, after age 59½ there is no 10 percent penalty on the taxable income portion of policy loan proceeds. Because interest on investments of comparable risk, such as Treasury bills, is taxable as earned, the total tax deferred return on cash values often exceeds that on such comparable investments. With the single premium policy, the only portion subject to taxation is the income portion of proceeds actually withdrawn as a loan.
  6. As a safe haven from future potential creditors – In many cases life insurance cash values are afforded significant protection under state law from the claims of creditors. The amount that is exempt from creditor claims varies from state to state. Because single premium policies permit the highest potential cash values, they also provide the greatest potential safe haven from creditors.
  7. To build a fund for retirement income – Similar to deferred annuities, cash values in single premium policies accumulate on a tax deferred basis. Also, distributions or loans from single premium policies that are classified as MECs are taxed similarly to distributions from annuities. The nonforfeiture options under a single premium policy are essentially identical to the payout options for annuities. Therefore, policyowners can use a single premium policy to build a tax-deferred fund for retirement, similar to a deferred annuity, while also guaranteeing a death benefit in excess of that paid from an annuity if the insured dies before retirement.
  8. As a means of eliminating the tax liabilities on corporate retained earnings – If used in conjunction with some other bona fide corporate purpose, such as key employee insurance, the company can contribute substantial amounts to single premium policies and reduce exposure to the tax on excess retained earnings. This may still give the company flexibility to use the cash values at some later date for other corporate purposes.
  9. As a vehicle for financing an employer’s obligation under nonqualified deferred compensation plans – Although companies cannot assign cash values in single premium policies to employees without such amounts being currently taxable as compensation to the employees, employees generally feel more secure if promises under a deferred compensation plan are financed with earmarked assets. A single premium policy can provide reasonable tax-deferred earnings to pay deferred compensation benefits at retirement and tax-free death proceeds to pay benefits for a deceased employee’s family under the agreement.
  10. As an investment vehicle for a net rollover that is not tax-free – Generally, a tax-free rollover to an IRA is the preferred rollover vehicle for distributions from qualified plans that would otherwise be subject to tax. However, participants may not roll over certain nontaxable portions of such distributions, such as amounts attributable to PS 58 costs in insured pension plans to an IRA. They may invest these after-tax portions in a single premium life policy and continue to enjoy tax-deferred growth. Also, single premium policies could be suitable investments for other types of large after-tax or tax-free dollar receipts such as after-tax proceeds from the sale of a business, tax-free proceeds from a life insurance policy, or the proceeds from a maturing tax-free bond issue.
Reproduced with permission.  Copyright The National Underwriter Co. Division of ALM

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