Do you need a million dollar life insurance policy?

Van Richards, ChFC®Posted in term life insurance last updated on August 24, 2019

If you are shopping for life insurance, you may be wondering if you need a million dollar life insurance policy or not. How do you know if you need that much life insurance? The best way I can answer that question is by telling you a short story of a client that bought such an insurance policy twenty-seven years ago. Regretfully, she died unexpectedly within nine months of buying the policy. This is a true story of how life insurance helped her husband and three children to continue their lives without her. Given that, I am not using their real names, and a few details have been changed to protect the client’s privacy.

A real-life story

By understanding what the life insurance did for one person’s family, you may better understand what a million dollar life insurance policy could do for your family. And, if you are self-employed or a business owner, you will see what a million dollar life insurance policy could do for your business and family.

Additionally, in this article, I’ll cover these other vital points.

Determining the need for a significant life insurance policy
Choosing the right term length
Using advanced financial planning techniques for substantial life insurance policies
The buying process
The price of a $1 million dollar life insurance policy, just for you

The story of Jack and Jill

In 1992, I met a husband and wife that owned five retails stores in Houston, Texas. For this article, let’s call the couple Jack and Jill. They were married, but they were also business partners. Jack took care of the operations of the business while Jill handled the finances. It was a perfect partnership. They loved each other, and they loved their work.

Jack and Jill knew that the business and their family were dependent on both of them. Their company was set up as a corporation and had a separate line of credit with their banker. However, Jack and Jill were personally responsible for the line of credit. As you will soon see, the structure of their business was important.

Calculating how much life insurance they needed

When we met, Jack and Jill knew that they needed life insurance. However, they were like a lot of people. They were confused about what to buy and how to buy it. They needed a guide to help them obtain the right coverage. Luckily, we met. We discussed what would happen to the business if either of them should die. They both agreed that they could not see continuing their business without the other.

Based on that, we discussed what would happen to the business if either one would die. Jack and Jill concluded that they would either sell their business or liquidate it. Their company did have debts with vendors, and they had a personally secured line of credit with their bank. In other words, if the business could not pay the debt, Jack and Jill would be liable for the debt.

Next, we discussed their personal debt and the level of their monthly household expenses. They had three children. Consequently, they knew that if one parent died, the other would need the deceased spouse’s income to continue. I explained to them that if one of them died, they more than likely would not need to replace the deceased spouse’s entire income. For that reason, they planned on only replacing 75% of the deceased spouse’s income.

In 1992, they were both fifty years old. They had not saved much for their children’s education. Although, they felt strongly about helping their children get a higher education.

The cost of college

Figuring in college cost

Jack and Jill’s intent was to pay for college out of their current income. At the time, the total cost of a public four-year college degree was about $38,745. As a side note, if you are planning for a four-year college degree now, it is approximately $68,000 for a public college. By the way, that is for four years. Private college is substantially more. College cost over the past thirty years has risen at an inflation rate of about 3.2%. College costs are expected to increase at about 4.9% over the next 20 years. Given that, twenty years from now, a public college four-year degree will cost about $177,000. In a moment, I’ll discuss how that figures into the need for a million dollar life insurance policy.¹

What if you cannot afford college?

With Jack and Jill, once we looked at their current cash flow and expenses, they could not afford to pay for all three children’s education out of pocket. I suggested three solutions. First, I suggested that if they were committed to helping their children go to college that they consider loans. The second and third solution involved them having a talk with their children about borrowing money. I explained, that if they could not pay for their children’s education, the children may qualify for their own loans. That would mean their children would pay for their own education.

They did not like that idea, so they asked what the third suggestion was? Hearing that, I showed Jack and Jill how they could share the cost of paying for college. If their children wanted to go to college, they could qualify for loans to pay a portion of the cost. After that, Jack and Jill could apply for loans to pay for the remainder of the cost.

Jack and Jill were both fifty years old at the time, and they had not saved much for their children’s education. Although, they felt strongly about helping their children get a higher education. For this reason, sharing the cost was a compromise they agreed upon.

Jack and Jill wanted a million dollar life insurance policy

After considerable discussion, we concluded there were three things that the life insurance needed to cover. Replacing one spouse’s income was paramount. Second, was paying for their children’s education. The third, was paying personal debt such as credit cards and their home mortgage. They both agreed, that if something should happen to either one of them, that the business would be sold or liquidated. In conclusion, they decided that they needed a million dollars of life insurance on each of them.

Choosing the right term length

Also, Jack and Jill agreed that they would only need life insurance for twenty years. They anticipated all their children completing college within the next ten years. Also, we calculated that they could pay off the student loans within the following ten years. Given that, ten years to complete college and ten years to pay off the loans added up to a total of twenty years. Consequently, the twenty-year term life insurance fits best. We also did talk about the selection of the life insurance company. They did end up selecting a policy from one of the strongest life insurance companies at that time. That company is still one of the top 10 life insurance companies today. Rather than go into that part of the conversation, I’d encourage you to read my other article, Top 10 Life Insurance Companies.

Keeping the business in mind

Even though Jack and Jill decided that they would discontinue their business if one of them should die, there were other potential problems to consider. What if one of them died and the company had credit problems, or someone sued them in the future? Plus, what about estate taxes?

Most life insurance death benefits are tax-free. However, if you purchase life insurance with the wrong owner, premium payer, and beneficiary, it can cause the death benefit to be taxable. At the time, estate taxes were a consideration. In 1992, the estate tax exemption was only $600,000. Plus, if the life insurance was payable to either spouse, it may be attachable to the business debts. Or, if someone sued them or the business, they may have some personal liability. Furthermore, if their business had to declare bankruptcy, the death benefit may be drawn into the eligible assets for a settlement.

Using a trust to own large life insurance policies

For that reason, I suggested that they consider an AB trust. The trust would assure that the death benefit would be used for the purposes they intended. They wanted life insurance to replace a spouse’s income, pay for college education, and settle their personal debt.

How an AB trust works

All the mechanics of an AB trust are complicated. Plus, it needed to be set up by an attorney. I’ll explain some of the important highlights. In general, the AB trust is a separate entity, almost like another person.

The reason the AB trust was useful at the time was that husbands and wives could only pass $600,000 without estate tax. If they moved more than that amount outside of their married estate, that portion over $600,000 was taxed at 55%. A married couple had an unlimited amount they could pass to each other. Although, at the time, if one died without using the $600,000 exemption, they lost that exemption. At the time the AB trust worked well because it allowed the deceased spouse’s estate to take advantage of the $600,000 exclusion.

Uses of the AB trust today

On a side note, today the AB trust is still used to separate funds at the death of the first spouse. But not so much for estate taxes. The current estate tax exemption is $11.4 million for individuals and $22.8 million for married couples.² In 2010, Congress passed the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (“TRUIRJCA” for short). As a result, the marital exemption was given portability. In other words, if one spouse died, they can now pass their estate tax exemption on to their surviving spouse.³ An AB trust is no longer necessary for that purpose. Yet, the AB trust does still allow spouses that have a potential for future liability to separate funds to a trust at the first spouse’s death. Now, the AB trust is used more to guard assets against future liabilities.

Getting the trust and the million dollar life insurance

The AB trust purchased the life insurance and paid the premium. Since it was a separate entity, it would protect the assets from Jack and Jill’s personal or business claims. In addition, it could accept the death benefit of the life insurance without causing any estate taxes. Since they lived in Texas, there would be no state death taxes as in some states.

The AB trust needed to be set up before the life insurance policy being issued. If the life insurance existed before the trust, it would have to be gifted to the trust. That would cause the death benefit to be included in Jack and Jill’s estate for three years. For that reason, Jack and Jill had to see an attorney to set up the AB trust.

Keeping the life insurance out of the estate

For the AB trust to receive money, it had to be gifted by Jack and Jill to the trust. At the time, an individual could gift up to the $10,000 without estate tax issues.⁴ The life insurance premiums were only about $1,200 each at the time. So, they could gift the premiums to the trust, then the trust purchased the life insurance and paid the premium annually.

Equally important, is the annual maintenance of the trust. This still applies today. Each year, when money is gifted to a trust, the trust must send a notice to the beneficiary or the beneficiaries’ guardian. The notice is called a Crummey Letter. It was named that because of the court case that was involved in the precedent of the notice. The Crummey Letter needs to give the beneficiary or guardian no more than thirty days to access the gifted money. After that time, the trust can use the gifted money to pay the life insurance premium. Most of the time, the attorney that draws up the trust will supply you with model Crummey Letters for the trustee of the trust to use yearly.²

Meeting with the attorney

I introduced Jack and Jill to an attorney that I had worked with in the past. I went with them to their appointment so we could coordinate the life insurance and the AB trust properly. After describing their situation and our conversations, the attorney agreed that an AB trust would be an excellent way to set up the million dollar life insurance policy. However, he explained that coordinating the trust with new wills for both Jack and Jill would be in their best interest.

Within an hour, all of the details to the will and the trust were worked out. I also had drawn up the life insurance applications so we could start the application process. I explained the timing, and the attorney agreed with that process. Consequently, the life insurance company could go through the exams, and the paperwork now. In that order, the life insurance company would hold off on issuing the life insurance policy until the attorney had completed the will and trust. To that end, Jack and Jill could sign the will and trust. There was one other step, gifting the money to the trust. After that, the life insurance policy would issue the life insurance policy.

Establishing a trustee and a guardian

After the trust was issued and the documents signed, a system of paying for the life insurance had to be established. Jack’s brother John served as the trustee for the AB trust and Jill’s sister Sarah was serving as guardian for their children. Jack and Jill made out checks to the trust for the life insurance premium. John established a bank account for the trust. The checks were deposited to the bank account. Following that, John, as the trustee, sent the Crummey Letters to Sarah serving as the guardian. After the appropriate time, John paid the premium to the life insurance company.

When establishing a trust, it may seem like a lot of steps for nothing. However, the steps were taken to avoid the potential of estate taxes. Plus, the process removed the life insurance policy from potential creditor claims, personal liability, or business liabilities.

All in all, the process did not take that much effort on Jack and Jill’s part. We spent about two hours in two meetings. We met with the attorney, which took about an hour. The will and trust were couriered to Jack and Jill. They signed and returned the documents. They had a few conversations with their relatives that served as trustee and guardian. I personally dropped off the policy and got their signatures for the receipt, and it was done. My goal was to make the process easy and accurate.

The worst tragedy did happen

Six months later, I got a call from Jack. He told me that Jill had been diagnosed with an aggressive form of lung cancer. Jill never smoked and had been in good health in previous years. So, this was devastating news for their family. He wanted to confirm that the life insurance policy was still going to work, even though they had bought it six months earlier. I confirmed that everything was done by the book and in good order. Regretfully, Jill only lived three more months.

Shortly after Jill passed away, I met with Jack and his brother to help them fill out the life insurance claim form. Within a few days, I got a phone call from the life insurance company, asking me a few questions. Since the policy had been purchased less than a year ago, they wanted to confirm a few items. Nothing was out of order. Within about two weeks, the life insurance company sent a payment confirmation to Jack’s brother John because he was the trustee.

million dollar life insurance check

Delivering a million dollar check

I met with Jack and his brother again to deliver the million dollar death benefit. No matter how many times I deliver a check, it never gets easy. The emotions of the family are overwhelming. They are still struggling with grief and yet so grateful for the guidance.

The plan worked

The goals from the beginning were to replace the deceased spouse’s income, provide for education for their children, and settle their personal debt. In the meeting with Jack and John, we discussed how to best proceed. The life insurance policy death benefit was deposited into the trust account. The trust paid off Jack and Jill’s mortgage and their personal creditors. That took about $100,000. I helped John establish an annuity account that was owned by the trust. The annuity payment was made to Jack.

When Jack and Jill’s children got to college age, Jack did take out a loan as we had discussed. His children took out small loans. Although, Jack ended up paying for about 70% of the four-year college expenses.

How Jack’s life proceeded

Jack liquidated the business as much as he could. Because of the company’s debts, their business was forced into bankruptcy by the company’s creditors. Because the trust held the death benefit, the life insurance proceeds were not attachable to the bankruptcy. This is a crucial point to notice. If you have a business, the separate structure of a corporation can help lessen the liabilities of the company upon the business owners.

Jack never went back to work. He spent time with his children. Additionally, he put in a lot of time doing charity work. The annuity paid jack about $20,000 per quarter. About five years after Jill’s death, Jack remarried.

What did the death benefit do?

Last month, Jack’s second wife, Sandra, called me to let me know that Jack passed away. He was seventy-seven. It was a sad moment to end a full life for Jack and his three children. It was all made possible by the grace of God and thoughtful planning.

Here are the end numbers of what the million dollar life insurance policy did from beginning to end.

$1,000,000 death benefit paid in 1992
$100,000 was used to settle personal creditors.
$900,000 was invested in an annuity to pay quarterly payments to Jack
Over 27 years, the annuity paid Jack a total of about $2,274,000.
After Jack’s death, the annuity paid his second wife the remainder value of about $593,000.
The approximate rate return from the amounts of money Jack received was about 9%

The returns on the annuity do differ from annuities available today. This is the historical experience. Just to be clear, this is not a guarantee that these returns could happen again in the future.