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Life insurance for your heirs

Do you need life insurance? » Life insurance for your heirs

Should you buy life insurance in one lump sum?

The short answer is, well, it's complicated. In fact, single-premium whole life, or SPL, may be one of the most overlooked, misunderstood, and hence rarely recommended forms of life insurance available today.

Which is a shame, because it can potentially save your heirs a bundle by passing their inheritance along to them tax-free.

Alternative to variable annuities

Back in the 1980s, SPL became a popular investment alternative to variable annuities. Like annuities, SPLs grow tax-deferred, even today. Unlike annuities, you could take withdrawals from your SPL tax-free back then, and the death benefit passed to your heirs free of federal income tax, while annuity beneficiaries assumed the tax position of the deceased.

Its best-of-both-worlds reputation soon led to rumors of widespread abuse.

"What people were allegedly doing was, they would borrow money to take out the policy and then borrow from it to avoid taxes," says Judith Hasenauer of Blazzard & Hasenauer, a Florida firm that advises insurance companies.

In 1988, Congress enacted Section 7702A of the Internal Revenue Code, which effectively closed the tax-dodge loophole by classifying SPL as a modified endowment contract, or MEC. As a result, withdrawals from SPL policies are taxed as ordinary income, the same as annuities.

Once rumors spread that SPL had "lost its tax status," investors and financial advisers alike turned their backs on single-premium life as an investment vehicle, despite its advantages over variable annuities as an estate-planning instrument.

Death benefit passes tax-free

The big advantage of SPL is that it passes the death benefit to your heirs tax-free (although there may be estate taxes to consider). In many cases, those benefits also will pass to heirs outside of probate, a real plus for larger estates.

"If you put $50,000 into both a variable annuity and single-premium life policy and they're both worth $200,000 in death benefit, there is zero tax consequences for the SPL if it's been set up correctly, while you're going to have $150,000 in income on the annuity contract that the heirs will have to pay tax on at ordinary income rates," says Hasenauer. "The best you can do with the annuity is amortize that tax hit over five years."

Because the premium is paid in full upfront, there's no danger that the policy will accidentally lapse. What's more, the insurance portion will be entirely paid by investment gain rather than with annual premiums. "That means it's paid with pretax dollars rather than after-tax dollars," Hasenauer notes.

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On the minus side, you must be able to qualify for life insurance and you won't be able to increase the death benefit of an SPL policy without additional underwriting.

Dan Prescott of Prescott Pailet Benefits of Dallas, admits he rarely sees single-premium life used as a stand-alone product these days. Where it comes in handy, he says, is as a means to consolidate stray life insurance policies in an estate through a 1035 exchange.

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