Conventional wisdom: you should only pay insurance coverage for significant potential losses that would represent a serious financial hardship. Most people need insurance on their home but not on a phone. Replacing a phone is annoying but, unlike losing a home, wouldn’t represent a financial catastrophe for most of us.
If we apply this principle to life insurance, only people who are the primary breadwinners of their household and whose death would cause significant financial hardship to their loved ones should get life insurance. After all, life insurance is designed to provide a safety net for heirs and dependents, not as an investment vehicle.
If this is true, wealthy people who don’t have debt are wasting their money on life insurance, right? Their death wouldn’t cause their family financial difficulties and they could invest their money much more effectively in other financial products.
Not so fast, say financial advisers who specialize in estate planning.
There are scenarios where life insurance can be a valuable, even necessary, element of a high-net-worth individual’s investment portfolio. Here are two worth considering.
The Asset Rich, Cash Poor Scenario
If you own a business or have a lot of property, most of your money is probably locked into assets that are worth a lot but are hard to sell quickly in an emergency. That is usually not a problem, except when you die. Wealthy people have to pay capital gains tax, which means the government owns a big piece of their estate. When you die, your estate can choose to either pay the government for its share in your estate with cash or sell your assets and share the proceeds with the taxman and your heirs.
For instance, if your assets are worth $100 million, you can expect about half of that to go toward federal and state taxes. In most cases it would be impractical and certainly not a good investment to have half your net-worth in cash, just in case you died. Still, your estate will only have nine months to pay this huge tax liability. If your estate hasn’t got the liquid assets to pay the taxman, it could throw your heirs into fire sale mode and force them to liquidize your assets below market value.
A life insurance policy could provide the necessary liquidity to pay your estate’s taxes without having to keep huge reserves of cash or forcing your heirs to auction off your business, farm, yacht or Bentley.
Life Insurance as Tax Mitigation
As well as providing life insurance, whole life insurance policies offer a cash value that grows as you pay your insurance premiums. It’s useful to see them as the bonds in a balanced investment portfolio. They provide boring but safe returns on investment. So why do financial advisers, at least those who don’t make a living off selling life insurance, generally discourage people from investing in whole life insurance? The answer lies in their high fees and because there are other tax-sheltered funds, such as 401(k)s, IRAs and Roth IRAs, that historically have generated a better return on investment.
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However, if you are filthy rich, you are already paying as much as you are allowed to in tax-sheltered contributions. Whole life insurance provides an additional asset class for your investment portfolio that offers low-risk, reliable, tax-sheltered growth. Some policies will even guarantee a minimum growth rate, which can translate into a generous return once account for the tax savings included.
In a Nutshell
So, do wealthy people need life insurance? No, yes and maybe. It all depends on what you mean by wealthy and how the assets are structured. If your net-worth is around $5 million (the federal estate-tax exemption) and you don’t have significant liabilities, then you probably don’t need life insurance.
On the other hand, if you are ultra-rich and you want to maximize the wealth you transfer to your heirs, and spare them the stress of scrambling for cash to pay for taxes, life insurance can be an invaluable estate planning tool.
Andrew is the managing editor for SuperMoney and a certified personal finance counselor. He loves to geek out on financial data and translate it into actionable insights everyone can understand. His work is often cited by major publications and institutions, such as Forbes, U.S. News, Fox Business, SFGate, Realtor, Deloitte, and Business Insider.