While we generally talk about the benefit of our clients buying life insurance policies on themselves and their spouses, we rarely delve into times when it might be appropriate to buy life insurance on a family member, like a child or even a parent.
Usually, you buy life insurance because you need to provide for heirs, so it’s unusual to insure someone else’s life. But it’s not unheard of and there might be times when you want to consider it.
That’s why it’s important to remember that universal life insurance is a lot more than just life insurance. Instead, it’s a way to provide funding for things your family members may need during their lifetime.
When You Might Consider Family Life Insurance
When we’re mentioning buying life insurance for a family member, we’re specifically talking about making that family member the insured on the policy. That means that it’s his or her death that would trigger the payout for the policy. Probably one of the most common reasons to do so is to cover pre-death medical expenses for a family member or to ensure his or her final expenses are paid.
One very effective way to purchase life insurance is to purchase coverage on parents so that the child who is the premium payer can actually create their own inheritance, a strategy otherwise known as be the beneficiary. Under this 401 Kaye strategy, individuals can ultimately enjoy a substantial, predictable rate of return because, at some point, their parent or parents will pass away. This is nothing more than the diversification of a portfolio and offers a degree of certainty that typical investment portfolios simply do not offer: a precise, guaranteed tax-free return.
So whether you want to receive $1 million, $5 million, or more during your retirement, you can use life insurance as a way to purchase future tax-free dollars on a deeply discounted basis. Most parents are willing to help their children and grandchildren build wealth by simply allowing themselves to be insured at no expense to themselves. Since the child, or grandchild pays the premium, there is no financial burden on the insured at all.
Another reason for coverage on a family member is to cover educational expenses. In this case, you can buy the policy on the child’s life, rather than your own, because the cost of insurance in a universal or indexed universal life insurance policy for someone young and healthy is much cheaper. Using your annual gift tax exclusion of $15,000, you can pay the premium on this policy. When that child reaches college age, he or she can take a loan out on the cash value, which will help cover education expenses.
The same thing goes for providing for a family member in the event that chronic care or long-term care needs arise. Some of the newer life insurance policies offer riders that can be used to cover long-term and chronic care. The proceeds from the rider are simply a tax-free advance of the death benefit. Any remaining death benefit will be paid to the beneficiaries upon death.
Now, while it may be advisable in some cases to buy life insurance on a family member, you need to remember that you can’t buy a life insurance policy on just anybody. You must have something called an insurable interest.
How to Establish an Insurable Interest
An insurable interest means that you’ll be directly and detrimentally impacted when someone passes away. “Directly” means that you have a direct connection to that person. You might be sad if a celebrity passes away, but that doesn’t mean that you can go out and buy a policy on that celebrity.
Generally, it’s a given that you have an insurable interest in parents, children, spouses, and grandchildren. You don’t necessarily need to be financially dependent on them to have this interest. Depending on the amount of life insurance applied for, the emotional connection may be enough.
However, proving an insurable interest on aunts, uncles, and in-laws is a bit more difficult. In this case, you’ll need to show a financial connection somehow, like you own property or a business together. Business partners also have an insurable interest because if a partner in a business passes away, that will directly impact all of the other partners.
A basic rule of thumb is that you’ll have to prove that you have a personal or economic interest in the person’s life to buy insurance on that person. Another thing you’ll need to note is that it’s nearly impossible to buy interest on another person without his or her consent. Most insurance companies require a medical exam, or at the very least, medical records to determine someone’s insurability. The exception to this rule occurs when you’re responsible for that person, like a minor child or a disabled relative in your care. In these cases, you’re considered that person’s representative, so you can buy the policy on that individual.
Now, while buying life insurance on family members might have some benefits, there are some times where you might not want to own the policy. At the very least, you’re going to want to hold that policy in a trust.
When to Reconsider Insuring Someone Else
The most obvious reason you might not want to put insurance under someone else’s name is when you’re dealing with someone who might not have the best financial management skills. For example, say you buy a policy to cover your grandchild’s college and you make that grandchild the owner and insured of the policy.
That grandchild could just borrow the full amount of the cash value and then waste it on something entirely different. When you make that person the owner, he or she will have a lot of control over the policy.
Another scenario is when the person is not mentally capable of handling a policy, like in the case of a disability that causes cognitive issues. In this situation, you’ll likely want that policy managed for the individual. If the insured can’t manage that policy responsibly, you might want to put it in a trust.
When a policy is in a trust, it’s the trust that controls the funds on the policy, not the insured. If the trust is structured as a discretionary trust, where the trustee is responsible for doling out funds on his or her own best judgment, you can prevent financially irresponsible people from accessing it.
If you have an insurable interest in someone else, you can buy a policy on that individual. These can be useful to cover educational or medical expenses, but the policies might allow that family member a bit too much control. That’s why you need to pick the right policies and discuss your strategy with a financial manager who specializes in this type of insurance. Contact a Howard Kaye advisor today at 800-DIE-RICH for more information on buying insurance on family members.
