The Bottom Line of Happiness

Life insurance. There are many critically important needs to purchase life insurance for business owners: covering family as replacement income for lifestyle, covering debts or future college expenses, providing funds for business liquidity, providing funds for business buyouts, providing funds to pay taxes, helping to equalize an illiquid estate, providing funds in the event of a loss of a key person—the list is extensive and important. The reason that life insurance is so complicated and detailed is that it is the one coverage where there is absolute certainty that there will eventually be a claim. Death and taxes are both certain—but they only sell life insurance. Thus, some life insurance policies build up a cash value toward mortality, creating unique characteristics that also come with tax advantages.

All life policies are found on a continuum, from policies that cover a limited period, for a small amount of premium, no cash value, and high death benefits (term insurance) to an investment vehicle that will have high premiums, lifetime coverage, high cash value, and low death benefits (permanent insurance). The former tries to provide the most amount of coverage per premiums paid, and the latter tries to make the most use of the tax benefits afforded to life insurance policies. The higher the death benefit in relation to the premium, the lower the growth of the cash. The tax advantages were so good on life insurance policies before 1988 they passed a law (Technical Corrections Act of 1988, defined as modified endowment contracts, or MEC) to limit their use as tax shelters. Before the act, an insured person could buy a policy for an insanely low death benefit—essentially eliminating the cost of life insurance coverage and becoming a pure investment vehicle. The new law mandates a maximum level of premiums per death benefit to enjoy most of the tax benefits. Additionally, many insurance companies have designed their policies for high premium payments with very low costs, making the IRR (internal rate of return) extremely competitive.