Is a Donor Advised Fund or a Qualified Charitable Distribution better for me?

My client Sarah (name changed for obvious reasons) is a personal finance enthusiast.  As I shared in my first “Ask Sarah” post, she reads broadly in the field and graciously sends me clippings with sophisticated questions that send me sprinting to my spreadsheets and deep internet research to address. A little more background is in order.  She hates bonds, loves stocks, detests taxes, abhors fees of any kind and, due a lifetime of frugal living, has far more money than she will ever spend.  At 72, the after-tax portion of her Required Minimum Distributions (RMDs) go straight into her non-qualified investment account which naturally is invested entirely in equities of US companies.  To help people simplify their finances to make it big, I will periodically address Sarah’s questions. 

Sarah recently asked me which was better for her, creating and funding a Donor Advised Fund (DAF) or a strategy relying on Qualified Charitable Distributions (QCD)? She of course wanted to make a double play—funding a DAF with a QCD—but that is too good to be allowed by the IRS. 

Some definitions are needed.  A donor advised fund is an investment account, held at a financial institution, that allows a person to make a substantial gift or gifts, take the full tax deduction in the year the cash gift is deposited, and then advise on subsequent distributions to public charities.  I think of them as a charitable foundation for the middle class.  The key is the deduction is taken up front, not when the distributions actually do their good.  These allow for a bunching of charitable contributions from a tax perspective and became useful and popular when the now current tax code increased standard deductions and restricted the amount of state and local taxes and could be deducted to $10,000.  

The contribution reduces taxable income not adjusted gross income.  I find these to be excellent tools for people who experience a large windfall, such as a sale of a business or exercising of a large pool of stock options. In a year of high income and therefore taxation, they can reduce Uncle Sam’s cut and create a pool from which to make the world a better place in the future.  

A Qualified Charitable Deductions (QCD) is a direct payment from an IRA to a qualified public charity.  A person must have reached 70.5.  She can send $100,000 or the Required Minimum Distribution (RMD) whichever is less.  A QCD reduces a person’s Adjusted Gross Income (AGI).  This is both  beneficial and detrimental.  First, you don’t need to itemize to benefit.  Second, AGI drives many bad things for retirees on a tax return, from increasing how much Social Security is subject to taxation to how much you will pay for Medicare Parts B and D.  

For Sarah, this was an easy call. The QCD is preferable since she takes the standard deduction and is in the penalty zone for Medicare.  The simple principle that you can use to make it big here is this,  for one-time taxable events, a Donor Advised Fund can be a financial home run.  You get a deduction in a year in which you will pay high tax rates and fund charities with no further deductions in lower tax years.  For people like Sarah who are over 70.5 and expect to have ongoing and increasing tax and Medicare bills, a Qualified Charitable Distribution is likely to be the better choice.  

Michael Lynch CFP® is a financial planner at Barnum Financial Group in Shelton, CT.  His book “Keep It Simple, Make it Big: Money Management for Meaningful Life,” offers simple strategies for financial success.  His writings can be found at www.michaelwlynch.com

Representatives do not provide tax and/or legal advice. Any discussion of taxes is for general informational purposes only, does not purport to be complete or cover every situation, and should not be construed as legal, tax or accounting advice. Clients should confer with their qualified legal, tax and accounting advisors as appropriate. Securities and investment advisory services offered through qualified registered representatives of MML Investors Services, LLC. Member SIPC. Barnum Financial Group. 6 Corporate Drive, Shelton, CT 06484, Tel: (203) 513-6000. CRN202302-278810

Know the Enemy

Taxes may be the price we pay for civilization, as Oliver Wendell Holmes noted.  Paying taxes may also make us feel proud, even patriotic, as we are contributing to a society that has supported the success that makes our ability to pay taxes possible. But, as the late television star Arthur Godfrey said, “I could be just as proud for half the money.”

When it comes to investing, it’s best to adopt Godfrey’s view. Taxes can be one of the great obstacles to financial success. And it’s even worse for us in Connecticut, as our high cost of living and high property, gas, and sales taxes require us to earn more income, and therefore pay more taxes at potentially higher rates, than people who live elsewhere.  So, when it comes to our investing, every dollar we can save in taxes is a dollar we can grow for future support.

Fortunately, most of us can invest tax smart to fund most of our life goals.  

Governments potentially levy income taxes at three points in the wealth accumulation process: when we earn money, when that money grows in an investment, and when we sell the investment.  The more of these points where taxes can be avoided, the more money that will be accumulated. 

The first place to start for the retirement goals is the employer sponsored retirement plan, usually a 401(k) for private businesses, a 403(b) for schools, hospitals and non-profits, and a 457 for municipal and state employees. Every dollar contributed to these accounts reduces a person’s taxable income by a dollar and the money grows tax deferred until retirement, at which point income taxes will be due on withdrawals according to current law.  For a Connecticut resident in the 25 percent federal tax bracket, $10,000 contributed to a 401(k) saves an immediate $2,500 in federal taxes and other roughly $550 to $600 in state taxes. 

 This means that it costs $6,950 to save $10,000, and then that $10,000 grows tax deferred. Assuming an 8 percent rate of return and a 25 percent tax bracket and a 20-year time horizon, this is a difference of $457,619 in the tax deferred account compared to $318,045 if taxes were paid all along the way. (This is a hypothetical figure and is not indicative of any particular investment or product.  As with any market investment there are risks involved, and results cannot be guaranteed.  Actual returns could likely be higher or lower than this figure.)  The drawback to this account is the bill comes due eventually.  When the money is withdrawn, and it must start to get withdrawn in one’s early 70s, ordinary income taxes will be due on every dollar. This can make people very cranky. 

Roth IRAs are backwards 401(k) s. Contributions are made with after tax dollars. Under current law, however, they grow tax deferred and, if accessed properly, the gains will be tax free as well. Roth IRAs make an excellent complement to employer sponsored plans, and, for younger or people with modest incomes they are very attractive substitutes. They are limited by income, but back door strategies exist that allow even high earners to get money in Roth IRAs. In addition, many companies offer a Roth 401k option that is not income limited by the IRS. 

 Municipal bonds and deferred annuities may provide investors with opportunities to shield investment gains from taxes. Annuities allow any potential gains to accumulate tax deferred. For retirees living on modest incomes, transferring balances held in taxable CDs, for which the depositor is insured by FDIC, to fixed annuities, guaranteed by the financial strength of the issuing insurance company, can sometimes reduce income. 

Municipal bonds are an example of a tax advantage investment which may be suitable for some people.  For Connecticut residents, bonds issued by the state of Connecticut are exempt from state and federal taxes.  For a person in the 25 percent federal tax bracket, a 2 percent municipal bond is the equivalent of a 2.9 percent taxable investment. The higher one’s income tax rate, the more valuable the income tax savings on the municipal bond. 

The mother of all income tax dodges is the health savings account (HSA). A person or a family must have a qualified health plan to use it and these are increasingly popular.  Money contributed to an HSA avoids all taxes on the way in—even payroll taxes. Investment gains are tax free. If the money is ultimately spent on health care on the way out—an item on everyone’s budget, especially as we age—it’s not taxed again.  If available, people should consider maxing this out and letting the money sit for years and enjoy compounding until it’s needed in retirement.  Think of it as a tax-free IRA for health care expenses. 

As with all financial strategies, investment products, and services, none of these strategies is right for everyone. In most cases, a combination will be optimal. After all, we all have an interest in paying less taxes. Unless, of course, someone wants less money in retirement.

This article was prepared by Mike Lynch CFP® is a financial planner with the Barnum Financial Group in Shelton CT and is not intended as legal, tax, accounting or financial advice. Michael is a registered representative of and offers securities, investment advisory and financial planning services through MML Investors Services, LLC.  Member SIPC. 6 Corporate Drive, Shelton, CT 06484, Tel: 203-513-6000. He can be reached at mlynch@barnumfg.com or (203) 513-6032.

The opinions provided above are not necessarily those of MML Investors Services, LLC. The opinions provided are for general information purposes only. 

CRN202206-266874

Curing the Parking Disease

Anyone’s who’s ever lived in an impacted city can relate to the parking disease. This is the affliction that attacks a person who purchases a car to make life easier but then learns quickly it’s stressful to use it due to the difficulty of finding return parking.  In my San Francisco days, I cured this by finding a spot in front of my Mission-District Victorian apartment straddled by two driveways.  When my car exited, my motorcycle, hitherto parked on the sidewalk, entered. I always returned to “rock-star” parking.

Now that I’m well-garaged, I notice that investors are apt to catch a version of parking disease.  Yet here it’s not the car that can’t be used due to lack of parking, but their money due to an abundance of taxes.  You see, Americans are taught to defer and avoid taxes, which can be achieved with buy-and-hold equity investing, retirement plans, some forms of U.S. Government bonds, and non-qualified annuities.  This is often a sound strategy and should be a component of most people’s financial plan.  Yet if overdone and un-supplemented, when it comes time to use the money far more than a dollar needs to be withdrawn.  Taxes must be paid. This prevents people from using their money.

The cure for this comes from an unlikely place—mutual funds invested in a non-qualified account.  I say unlikely because most mutual funds in non-qualified accounts create taxes each year, with dividends, interest and often dreaded capital gains distributions.  They generate 1099s and add to a person’s tax bill.  As a result, strategies are often employed avoid these accounts to minimize these taxes.  

 But it’s a classic pay me now or pay me later.  Pay a little as you go or a lot when you want it.  The cure for one problem, annual taxation, becomes the cause of the tax problem later, a big tax bill.  Therefore, the cure for the problem later is to embrace the tax-problem now. The good news is that people rarely sell the investment to pay the taxes.  It comes from other funds. Effectively, these investment compound as if in a deferred account. 

Investing in mutual funds in a taxable account can be a smart-money move.  When it comes time to use the money, whether for retirement income, vacations, home improvements, whatever, you will likely have moved your tax-basis us each year and trigger little gain at point of use.  This will put a smile on your face.

This strategy is not a replacement for all tax-deferred investing, but rather a compliment to these other accounts. A tax-efficient plan will contain a variety of accounts (continue to p. 2) 

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Health Savings Accounts: avoid income taxes now and in the future if used for health care

Traditional IRAs and retirement plans: avoid taxes now but pay income taxes on withdrawals in the future.

Roth-style accounts: accept taxes now for promise of zero tax on future withdrawal if rules are followed

Non-qualified accounts that lock in long-term gains on low cost basis

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Each has its place, advantages and disadvantages.  But so too does the often maligned mutual funds in non-qualified accounts. You’ll be happy you have them later. 

To see how this may fit into your financial plan, schedule a financial check-up.  We’ll focus on your finances, so you can focus on your life. 

From Scarcity to Abundance: Two Types of Planning

For most of our lives, people practice the financial planning of scarcity. The fundamental questions we ask: Will we have enough? How much do we need? How can I best accumulate what I need?

We apply these questions to life’s journey. Do we have enough to purchase a house and how best to accumulate the down payment? If children arrive on our scene, how much will college costs and how to best accumulate it dominate when our thoughts turn to finances.

Our course, there is the focal point of financial independence: How much must we accumulate for work to be optional?  From here, we calculate the required savings to be containers and investments to grow the money.   

Our risk management focuses on protecting future accumulation. Life insurance replaces income that would have been earned if you pass at a tragically early age. Disability replaces income that you would earn but for your condition that makes working impossible. 

Since income taxes are an expense that reduces what we can save and invest, we do our best to kick this down the road with tax-favored—often tax deferred—accounts. 

Will We Have Enough? 

The key is we engage head on with the fundamental reality of the universe: resources are scarce, and success will only arrive if we allocate our treasure prudently.  At this point in our lives—which for most of us is most of our lives—money is scarce, and accumulations typically requires saying no to some of life’s luxuries so we can enjoy life necessities on time. The house, early in life, college for our children and, of course, generous income streams from our money piles once retired.  

I know this planning well and I enjoy it.  I started working professionally at age 32 and assisting people creating their infrastructure of success for young motivated clients was my specialty.  It still is today. 

You Have Enough, Now What?

The planning of plentitude is type two planning.  Except for the few of you who win the lottery or catch a big inheritance, you earn entry into this club with years of diligent work, building both human and financial capital.  Your marketable skills may build to earn more income than you ever imagined, allowing you to set aside more than we ever thought possible. Yet, in my experience, this is not necessary. People who earn a modest income and consistently set aside 10 percent of it will wake up one day with a revelation: I have more money than I will ever spend in my lifetime.  

Thus, the set of questions type two planners ask: How best to use and protect the money we created? After I’m gone, where is it going? The focus on investments may turn to income generation. The excess not needed to for this task remains growth for the future. Insurance and protection needs shift from replacing income to protecting the wealth from nursing home, lawsuits and sometimes even rapacious family members. 

Some of questions are quite big: Now that you know you have enough, what’s next? 

Either You Fly First Class, Or Your Children Will

As I age, and my clients do along with me, I find that it’s hard, sometimes impossible for people to shift from type one to type two planning.  The very disciplines hardened to habits—spending wisely, saving regularly, deferring gratification—that produced fantastic financial success work to prevent people from enjoying wealth materially. (I say materially, because the psychological effect of knowing one is secure is a real and probably the primary benefit) It’s not so much a denial that our lives will end, but rather an inability to completely understand—and totally accept—that at some point, even if it’s a mere day prior to our passing, that we have enough resources, we’re never going to run out, and money is no longer a scarce resource in our lives. 

At this point, we certainly can’t have it all. But we can purchase what we want and hopefully, be at peace that we pulled our weight in this world. We may even transition the accumulation effort and the important role it played in our lives to creating structures—gifting and legacy programs—ensure our efforts produce blessings well into the future.  None of us gets out of here alive and since we aren’t Pharos, we won’t be taking it with us. 

 Michael Lynch CFP is a financial planner with the Barnum Financial Group in Shelton CT and the author of Keep It Simple, Make It Big: Money Management for a Meaningful Life, October 2020. He can be reached at mlynch@barnumfg.com or 203-513-6032.

Securities, investment advisory and financial planning services offered through qualified registered representatives of MML Investors Services, LLC. Member SIPC. 6 Corporate Drive, Shelton, CT 06484, Tel: 203-513-6000. Any discussion of taxes is for general informational purposes only, does not purport to complete or cover every situation, and should not be construed as legal, tax or accounting advise. Clients should confer with their qualified legal, tax and accounting advisors as appropriate. CRN202304-281431

Sarah’s Question: Should I use an Annuity Strategy to Reduce My Taxes?

My client Sarah (name changed for obvious reasons) is personal finance enthusiast.  She reads broadly in the field and graciously sends me clippings with sophisticated questions that send me sprinting to my spreadsheets and deep internet research to address. A little more background is in order.  She hates bonds, loves stock, detests taxes, abhors fees of any kind and, due a lifetime of frugal living, has far more money than she will ever spend.  At 72, the after-tax portion of her Required Minimum Distributions (RMDs) go straight into her non-qualified investment account which naturally is invested entirely in equities of US companies.

To help people simplify their finances to make it big, I will periodically address Sarah’s questions in writing for all. 

Sarah’s most recent missive contained an article from a very reputable personal finance magazine’s website with the headline, “Shrink Your RMDs in 2021 and Beyond,” with a note attached asking me to research and discuss when we next meet.  The strategy on which the article focused was the use of Qualified Longevity Annuity Contract or QLAC to remove up to 25 percent of a person’s IRA or $135,000, whichever is less, from the RMD calculation.  A QLAC is what is known as a deferred income annuity. It is blessed by the IRS and has some special rules.  It must be funded with pre-tax retirement money. The value of these funds is removed from RMD calculations. Income must be taken by the time a person is 85.  In theory, since the person does not have a long-life expectancy at that point, it will provide a high level of income at this advanced age and therefore hedge the risk of living a long life. 

These contracts are well-reviewed by academic retirement researchers as a way to address running out of money, a task for which they seem well suited for the right person.  This, however, is not Sarah’s concern.  Sarah wants to minimize her taxes.  The question: is this a good strategy for her?

To answer this, I built a spreadsheet.  But before I get to that, it’s important to return to a basic principal of money, investing and taxes.  It’s not what you pay that matters, but rather what you keep.  In other words, I can minimize eliminate my income taxes by eliminating my income.  I pay no tax, but I don’t make rent either.  Sarah’s goal is not to minimize taxes per se, but to avoid having these taxes erode her pile of money.  This is the standard by which this strategy must be judged in her case.

I built a model that compared the effects of investing the $135,000, taking RMDs, paying tax on the RMDs and then investing the after-tax proceeds in a non-qualified investment account with deferring the income in a QLAC. The firs scenario s is exactly what Sarah does.  I use her real marginal tax rate, a combined 28 percent and historical rate of return, 8.95 percent.  For the QLAC, I secured a quote from a highly rate insurer. 

Given these accurate historical assumptions, from today until Sarah reaches 84, she will pay just over $33,000 in taxes.  This makes her sad, but it’s only part of the story.  Her IRA will be worth just over $225,000 and her new investment account funded with after tax proceeds will be $135,000 for a total value of $358,000.  This is of course not guaranteed by any government or insurance company, but that’s neither Sarah’s concern nor her goal.  

Her QLAC value is worth $135,000 at 84, and that’s a return of premium should she die.  At that point, she can get $18,614 in income for life.  This income is taxable.  By age 90, she will have recovered her deposit and it’s only then that real returns come from the contract.  If she makes it to age 100, she will have an after-tax value of $493,000 with the QLAC.  This compares with over $1.2 million from leaving it in the IRA, taking the RMDs, paying full tax and investing the proceeds.  Sure, she paid $135,000 in income taxes, something for which many other Americans will be grateful.  But her after-tax value is projected to be far greater.  In Sarah’s case, the QLAC would be expected to destroy wealth and she should avoid it.  

The lesson: Don’t fear taxes but rather seek after-tax total return. It’s not what you pay that matters.  It’s what you keep that counts! Keep this simple principal in mind and you will be on your way to making it big.

Michael Lynch CFP® is a financial planner at Barnum Financial Group in Shelton, CT.  His book “Keep It Simple, Make it Big: Money Management for Meaningful Life,” offers simple strategies for financial success.  His writings can be found at www.michaelwlynch.com

Representatives do not provide tax and/or legal advice. Any discussion of taxes is for general informational purposes only, does not purport to be complete or cover every situation, and should not be construed as legal, tax or accounting advice. Clients should confer with their qualified legal, tax and accounting advisors as appropriate. Securities and investment advisory services offered through qualified registered representatives of MML Investors Services, LLC. Member SIPC. Barnum Financial Group.  6 Corporate Drive, Shelton, CT 06484, Tel: (203) 513-6000. CRN202210-273165

Sarah’s Dilemma: Caught between A Long-Term Care Policy and a Hard Place

Sarah, a longtime financial planning client, recently called me with a conundrum. Like thousands of other retired and soon-to-be retired Americans, she’d received an unwelcome letter regarding her long-term care insurance policy she’d purchased decades back from a long-gone agent. The letter served as an introduction from a new agent who presented himself as a long-time expert in the field, with a resume that bounced him from salesperson to home office support and now back into the hurly-burly of independent insurance sales. She called him and he informed her that her premium would skyrocket at renewal, with more such bursts likely in the future. He had new options that might be of interest to her and welcomed a chance to discuss them.

Sarah asked for my opinion. I counseled her to go ahead with the discussion, but to beware that incentives matter and that this agent would get compensated for his time only if she made a move to a new product. By doing some math, she could make a good if difficult decision.

Risk Number One for Middle-Class Americans

Funding long-term custodial care expenses is a real risk for many Americans. In fact, I figure it’s the only risk that can turn a middle-class millionaire into a ward of the state, wiping out a lifetime of accumulation in a miserable process. Nary a month passes when I don’t send out large checks from client account to fund essential care not reimbursed by health insurers or Medicare. I call it paying rent in the wrong kind of hotel.

The insurance industry boldly stepped up to meet the challenge with the first insurance products for this risk in the 1970s. In 1996, the Health Insurance Portability and Accountability Act (HIPAA) standardized them and gave them tax preference like health insurance. Although these policies have never been cheap, prudent people in their 50 and early 60s could once address this risk for a few hundred dollars in monthly premiums.

We could customize policies. People concerned about wasting the premium dollars could elect return-of-premium riders that made the policies both lose/win and win/win in the best sense. 

If they lost and needed the coverage, the plan paid out big time. A win. 

If they died without using it, again, a win considering the alternatives. A win.

In some cases, every dollar of premiums paid was refunded to a stated beneficiary. Spouses could share benefits. Policies could be paid up all at once or over a decade.

These were incredibly useful planning tools for protecting people’s wealth.

Reality Bites

Then the new reality struck. Years of low interest rates and higher than projected usage put the squeeze on the carriers. Companies can increase the premiums on these policies if their state regulators agree it’s necessary. The rate increases started coming in the new millennium. I often run the numbers for clients and report that even at the elevated premium, the policy is worth keeping. In these cases, the new premiums are still less than a third of what premiums on similar new policies would be. The regulators often approve lower increases than the carrier’s request.

In other cases, the higher premiums make keeping the policy prohibitive. However, carriers always offer options to downsize the policy and reduce the premium by adjusting such variables as inflation protection, how long the benefit will pay, the amount of benefit, and the waiting period before collecting benefits.

Sarah’s Case

Back to Sarah’s question. She is now financially secure, although this wasn’t always the case. She started a business in her 50s and she was in the building process when she purchased this policy from a leading company in the field. Today, she is fortunate to be able to self-fund care if necessary.

Her policy is robust by any standard, poised to pay a daily benefit of just over $450, growing at 5 percent compound. Today, she is approaching 70 and the three-year benefit is worth roughly $500,000. It’s quite a bargain by contemporary standards at its current annual premium of $6,000.

Enter the dreaded letter informing her that the new premium will be roughly $1,000 a month, with more boosts likely in the future. The good old days are indeed gone for this insurance. The good news is that she has not needed it. The bad news is that she has a difficult choice of whether to keep it.

Option One: Pay the New Price

One option is certainly to pay the new premium. For people with assets and free cash flow—the only ones who should consider purchasing these policies—I believe in beginning with rate of return analysis. In other words, knowing for sure what the maximum potential benefit is at each age and what the minimum premium is going forward, we can perform a best-case rate of return on the policy. We can also compare to alternatives, such as investing the money that would have gone to pay premiums.

In this case, the current policy, even at the new premium, provides substantial potential value.  At age 80, its potential value (if needed) is $815,000 of tax-free money—a 40 percent rate of return on the new premium invested. This compares with a sum of $170,000 for that premium if invested and earning her historical average of 8 percent per year.

Jump ten years to age 90, and the maximum policy payout increases to $1.3 million. The cost, however, is the $500,000 to which the premiums could have grown at 8 percent.

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The Math of Misery

This policy, typical of its genre, pays out on month at a time after a 90-day waiting period.  The big lose/win benefits only materialize if the care is needed for three years. According to a survey of actuaries conducted by the American Association of Actuaries, one in three policy holders will need a policy long enough to outlast the waiting period. Another study by an insurance carrier found a 5 percent chance of using a policy’s entire benefit.

Simple math multiplies the potential benefit by the likelihood of using it to find one way to look at expected value of insurance. With this adjustment, the insurance, if needed for the entire three years, is a good deal at age 80. By age 90, the investment bests it.

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Decisions, Decisions

I’m fond of saying that when it comes to insurance, you shouldn’t focus on analyzing premium and benefits; actuaries have already done so and in a competitive market they will be fair. Ask what happens if you need the policy but you don’t have it. In other words, focus on the error of needing the policy but not having it, rather than the risk of having it but not needing it. What will the former mean to you and your loved ones?

Given these numbers, if there was a return of premium rider on the policy, or if the policy was funding a special needs trust or otherwise protecting assets for a critical financial need, keeping it would be attractive if not crucial. In this case, however, Sarah’s financial circumstances have changed for the better and she can easily self-finance more years of care than she’ll likely ever use.

What Else is Out There?

As you’ve just seen, the question of how to address the current policy is not easy. Different people could easily form different conclusions depending on their risk tolerance for health events, their expected investment returns, and their preferences for shifting financial risks versus retaining them.

As you will see, the same can’t be said for the new options presented to Sarah. These ranged from useless to dreadful considering her situation. It really can’t be any other way, as every insurer must construct every insurance product with the same raw materials—interest rates, morbidity estimates, and mortality expectations. Given today’s low interest rates and the high rates of usage of this important protection, I’d expect any new policy to offer less, not more, financial value for the insured.

Restructure the Current Policy

Option one is to restructure the policy with the existing carrier. If the carrier is considered sound, this can be a good option. The 5 percent compound may no longer be needed, for example. Or a benefit can be reduced and a larger share of the risk retained. If the carrier is considered weak, however, this may be throwing good money after bad, as the future will just bring more difficult choices.

The new agent presented a reduction of the benefit by 56 percent to $200 a day. The change was linear and the relative payoffs remained the same as for the existing plan. This would be a real option with a sound carrier, but not here. 

Acquire a New Plan from a Sound Carrier

The next option presented involved a traditional plan with a sound carrier. Here the benefit is reduced to $100 a day. The annual premium is $2,780. This could be a useful amount for some home care in our market. That said, this is not a meaningful amount for Sarah, given her investments. Still, dollar for dollar, this plan potentially adds real value in the first 18 years if it is needed and completely used. If we apply the 35 percent probability of using it, the value is extinguished in less than a decade.

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Bet on a Sure Loser

As conditions have deteriorated for traditional long-term care insurance, the industry has developed hybrid plans that combine life insurance and long-term care insurance. These come in many forms and have evolved over the years as interest rates remained low. 

These innovative plans can provide some excellent protection in the right product for the right plan for the right client. In some cases, they accelerate the life insurance death benefit, free of income tax, at 2 percent a month. A $250,000 policy, for example, pays $5,000 a month until the policy is exhausted. In other designs, the long-term care benefit is substantially larger than the life insurance benefit. These policies are popular, representing 85 percent of all long-term care policies sold in 2018 and one in four life insurance policies.

Given the proposal sent to Sarah, she won’t likely be adding to these numbers. She was presented a hybrid plan based on a $75,000 whole life policy that, at best, pays $150,000 of long-term care benefit at $3,000 a month.

It’s easy to understand the pitch. If you need care, the policy provides $3,000 a month for just over 4 years. If you get lucky and don’t need it, you get the benefits of non-participating whole life of $75,000 death benefit. If you need the money in the meantime, you have some cash surrender value, since it’s whole life.

Given the right set of facts, this could work. It could even work well. The agent presented a one-time premium of roughly $69,000 and then suggested that IRA money could be used to capture all the benefits of a whole life plan as well as the attached long-term care protection.

Taxing Times

Sarah’s combined marginal income tax rate (federal and state) is 30 percent. She’d be taking roughly $100,000 out of an IRA to fund a policy with a death benefit of $75,000, a cash surrender value that never exceeds $70,000, and a long-term care benefit that an investment of greater than 4 percent would beat in the first ten years.

If not funded with an IRA, these numbers get a bit better. Still, it seems more like a test of diminished mental capacity than a serious proposal. These numbers simply don’t crunch. 

Keeping Current with the Times

Considering the choices, I believe that Sarah will eventually relieve herself of her long-term care premium, thereby relieving the carrier of the risk of paying a potential claim. Although not the ideal or intended outcome for either party as they entered their relationship, this result stems from the truism that sunk costs are sunk and as the world changes we must change with it.

Sarah’s increased wealth rendered the protection afforded by the insurance less valuable. For the carrier, the unpredicted collapse of interest rates and increase in longevity made keeping its intended promise at the premiums it initially wrote impossible. Logical thinking tells us that a decision may have been sound at the time it was made, even though its results didn’t turn out as expected.

That’s the case here. Sarah’s original choice to protect her family from the financial ravages of paying for long-term care was smart at the time. Now it’s smart for her and the carrier to part ways as friends.

Michael Lynch CFP is a financial planner with the Barnum Financial Group in Shelton CT and the author of Keep It Simple, Make It Big: Money Management for a Meaningful Life, October 2020. He can be reached at mlynch@barnumfg.com or 203-513-6032. His articles can be enjoyed at www.michaelwlynch.com.

Securities, investment advisory and financial planning services offered through qualified registered representatives of MML Investors Services, LLC. Member SIPC. 6 Corporate Drive, Shelton, CT 06484, Tel: 203-513-6000. Any discussion of taxes is for general informational purposes only, does not purport to complete or cover every situation, and should not be construed as legal, tax or accounting advise. Clients should confer with their qualified legal, tax and accounting advisors as appropriate.

Better to Go Direct

The time comes in most retirees’ lives when they are struck by an “ah ha” moment that changes everything. After a working life of systematic saving that often came at the expense of luxuries and adventurous experiences, they realize that not only are they financially secure for the rest of their lives, but that if they maintain their current lifestyle, they will make their children and perhaps grandchildren financially secure as well.

It’s at this point that the mindset shifts from scarcity to abundance. Since enriching the next generations has never been their dominant financial goal, this is often disorienting. I find myself recommending weird things for a financial advisor. Pay more to sit in the front of the plane, if not first class then at least business class or premium economy. Order the appetizers and top-shelf drinks. Purchase the luxury car. If you think something will bring you joy, pleasure or even transient happiness, do it. Purchase it.

Such thoughts recently entered the head of my client Mark. It only took a decade of my stressing this in his annual financial plan progress reports. A modest lifestyle, systematic savings, a strong pension, Social Security, and a wife working through retirement years will catch up to you at some point. When it does, you have too much money.

Mark asked me if he should he start converting his traditional IRA to a Roth IRA so his children would pay less tax on their inheritance. Through my prattling, he was more than aware of the SECURE Act’s slaying of the stretch IRA, a slang term for the ability to withdraw inherited IRA funds over the life span of the beneficiary. With this new law in effect, all the money must come out in ten years, a change that potentially increases taxes on, and therefore decreases the value of, one’s savings.

“So, your goal is to optimize the after-tax value of your retirement assets over two generations?” “Yes,” he confirmed.

I told Mark that I wasn’t sure about the answer to his question. It was an empirical question and I’d need more information from him. Mark, of course, is getting older and he’ll soon be required to distribute money from his pre-tax (traditional) IRAs. These distributions cannot be converted to Roth IRAs.

“Would you consider your children high, moderate, or low earners?” I asked, not knowing exact details of his family. I had a hunch due to years of conversations, but I needed confirmation. It turns out his daughter is a teacher and his sons earn their money as a police officer and an auto mechanic.

Gotcha, I replied, so they are likely in the same or a lower tax bracket than you, correct? “Likely lower,” he said.

Gotcha, I shot back. I pulled up a spreadsheet loaded with the current federal tax brackets on my computer, since we were Zooming.

I punched a few keys and demonstrated that Mark would likely pay more in taxes just so his progeny didn’t have to pony up at lower rates. This destroyed wealth and was not smart. His goal was to make his family’s life better, not make Uncle Sam richer.

Confirming that his goal was to optimize the after-tax value of his life’s savings, I suggested an alternative. When your required minimum distributions (RMDs) commence next year, you should use them to fund Roth IRAs for your children. If you like and trust their spouses, I added, you should do it for them as well.

You have more than enough income prior to these withdrawals which you are going to take. If you put them in an investment account in your name, you’ll pay tax as you go. Given current proposals on capital gains taxation, you may get whacked again at death. Get the traditional IRA withdrawals into Roth IRAs for your kids, and they will have a better chance of escaping taxation, under the current rules at least. Congress may change these rules to confiscate more money in the future, but at least you will have a fighting chance.

I switched over to the software I use that’s loaded with historical investment returns. These are never a prediction of the future, just as Mike Trout’s last year’s batting average says nothing about how he’ll hit this year. But it is what happened. It’s not commentary.

I showed Mark that 20 years of Roth IRA contributions for his three children into investments that he currently uses, if started 20 years ago, would have produced just under $1 million. That’s all tax-free and since it’s funded with RMDs, this strategy is not increasing Mark’s taxes either.

He’s a thoughtful guy. He said I’d given him a lot to think about. My hunch is that when his pondering is done, his kids are going to get three new accounts. It’s a win for Mark, a win for his kids, and a loss for the IRS. In my book, that’s a win, win, win, or a triple play.

Michael Lynch CFP is a financial planner with the Barnum Financial Group in Shelton CT, a member of Ed Slott’s Elite IRA Group and the author of Keep It Simple, Make It Big: Money Management for a Meaningful Life, October 2020. You can find more articles and videos at michaelwlynch.com. He can be reached at mlynch@barnumfg.com or 203-513-6032.

Securities, investment advisory and financial planning services offered through qualified registered representatives of MML Investors Services, LLC. Member SIPC. 6 Corporate Drive, Shelton, CT 06484, Tel: 203-513-6000. Any discussion of taxes is for general informational purposes only, does not purport to complete or cover every situation, and should not be construed as legal, tax or accounting advise. Clients should confer with their qualified legal, tax and accounting advisors as appropriate. CRN202406-267663.

The 3-Legged Retirement Stool

The following is adapted from Keep It Simple, Make It Big.

Imagine trying to sit on a two-legged stool. You would need impeccable balance, and even then, there’s a good chance you’d end up sprawled on the ground. Take one of those legs away, and it becomes even more challenging.

For the stool to be stable, it needs at least three legs. 

Saving for retirement is similar. Having just one or two sources of income is typically not enough. To make sure you have enough money in retirement, you need more legs—more sources of income—for stability.

Traditionally, the three legs of the retirement stool are Social Security, employer-sponsored pensions, and defined-contribution plans. 

Leg #1: Social Security

Social Security is an important leg of your retirement stool. It is a government-sponsored defined-benefit pension. As long as you have paid into the Social Security system for forty quarters, or ten years, or are attached to someone who has, you can qualify for these benefits. 

Although Social Security is sponsored by the government, it’s paid for by workers who pay taxes on wages during their lifetimes. The 2020 tax rates are 12.4 percent on income up to $137,700, half of which is paid for directly by the employee and the other half paid directly by the employer.

Benefits are calculated as a percentage of your average annual wage over a thirty-five-year period, with a cap on how much can be paid out. The average benefit paid in 2020 is $1,503 a month. The maximum at full retirement age is $3,011 a month. The 2020 maximum benefit is $3,790 per month for a person who waits until 70 to collect.

The program is designed to replace 40 percent of the average worker’s wage prior to full retirement age. It replaces much less for high earners. At the peak earning of $137,700, it replaces 26 percent at full retirement age.

The question to ask: Can you live on 40 percent of your average wage? If you are a six-figure earner, can you live on 25 percent or even less?

Probably not, which is why you need additional legs for your stool.

Leg #2: Employer-Sponsored Pensions

Employer-sponsored pensions have traditionally been the second leg of retirement’s three-legged stool. The style has evolved over the years. Today pensions take three prevalent forms: defined-benefit, cash-balance, and defined-contribution.

The traditional pension is a defined-benefit pension. Defined-benefit pensions, with a few exceptions, are solely the responsibility of the employer. Employers contribute money to a pool that must pay out a defined-benefit, typically a monthly payment, to an employee once they retire. The monthly payments can range from a few hundred dollars to $18,750, depending on the plan. An employee’s payments are based on salary level and the years of work for the company.

Cash-balance pension plans have become popular in corporate America. As life expectancy has increased, traditional defined-benefit pensions—which require companies to accumulate enough money to fund a stream of payments over an entire lifetime—have become a costly burden for many employers. Many have converted to cash-balance plans.

Like traditional pensions, the contributions and the investments are the responsibility of the employers. But unlike pensions, employees are shown an account balance to which they are entitled, not a stream of payments based on an earnings-and-tenure formula. Employers will typically contribute a set percent of an employee’s salary to the investment pool.      

The third type of pension—defined-contribution plans—is unique enough that it represents a separate leg of the stool.

Leg #3: Defined-Contribution Plans—401(k), 403(b), and 457 Plans

Defined-contribution pensions shift the responsibility for retirement funding and investing from the employer to the employee. The most common of these is a 401(k).

Unlike traditional pensions that guarantee a benefit, defined-contribution pensions guarantee a level of contribution, and even that is optional for the employer and subject to change at short notice. 

What is guaranteed, provided one’s employer offers a plan, is the right for an employee to defer a portion of their income, tax free, up to a government set limit. 

Some companies, but not all, offer after-tax and Roth options too. These allow employees to contribute after-tax dollars to the plan as well. In the case of the Roth option, both contributions and earnings can be withdrawn tax free at retirement provided the account was open for five years and the employee met age requirements.

The employee is responsible for making investment choices from those provided by the plan. Some plans do arrange for employees to secure advice for an additional fee. The amount of money an employee ultimately has at retirement is determined by the amount of contributions and the investment gains, or losses, on those contributions. 

Alternate Legs

Combined, Social Security, a traditional pension or cash-balance pension, and a defined-contribution plan make a sturdy retirement stool.

However, for an increasing number of people, the second leg is not available. Only one in five Americans who work in the private sector have a defined-benefit pension, and the proportion has been dropping for years. 

Fortunately, you are not limited to only these three legs. Many people rely on inheritance, family, charities, or part-time work during retirement to further supplement their income. Although these are valid income streams, you do not have complete control over them.

For this reason, to strengthen your retirement stool, you should also build personal savings. Individuals can save and invest in a variety of instruments including bank accounts, mutual fund and brokerage accounts, Individual Retirement Accounts (IRAs), Roth IRAs, and variable and fixed annuities. 

By working to build a sturdy retirement stool now, you can ensure your last decades are more comfortable.

For more advice on retirement savings, you can find Keep It Simple, Make It Big on Amazon.

Michael Lynch is a CERTIFIED FINANCIAL PLANNERTM professional with nearly twenty years of experience working with American families to craft plans that fund their dreams, educate their children, and finance their retirement. Michael has contributed to the Wall Street Journal and Investor’s Business Daily, and hosted Smart Money Radio for a decade. He’s served as an adjunct faculty member at Fairfield University and currently teaches financial planning to employees of corporations like Madison Square Garden and Yale New Haven Health Systems. Michael is a five-time Financial Planner of the Year for MetLife and a 2019 inductee to the Barnum Financial Group Hall of Fame. You can enjoy his latest articles and videos at www.michaelwlynch.com.

Representatives do not provide tax and/or legal advice. Any discussion of taxes is for general informational purposes only, does not purport to be complete or cover every situation, and should not be construed as legal, tax or accounting advice. Clients should confer with their qualified legal, tax and accounting advisors as appropriate. Securities and investment advisory services offered through qualified registered representatives of MML Investors Services, LLC. Member SIPC.  6 Corporate Drive, Shelton, CT 06484, Tel: 203-513-6000. CRN202210-272631

The Certainty You Must Prepare For: Death

The following is adapted from Keep It Simple, Make It Big.

Especially when you’re young, it’s easy to put off thinking about your death, but death is a certainty. Whether you like it or not, you will eventually die. At that point, you will lose all control over what happens to your estate—unless you prepare ahead of time.

If you want to have a say in what happens with your money, you can’t wait until you die or become otherwise incapacitated. You need to act now. Preparing for your death is not the most enjoyable task, but it is necessary.

Specifically, you need to create a last will and testament, a durable power of attorney, and a plan for any potential taxes.

Last Will and Testament

Everyone should have a will. Your will is the basic document in which you determine how your estate will be distributed and to whom. 

In creating your last will and testament, you will want to consider:

• Who will take care of any minor children

• Who will get what percentage of your assets

• Who will receive any collectibles or special items

• Who will be the executor of your estate

Don’t die without a will. The government then will decide who gets what, including the care of your children.

Every financial plan I complete tells clients to get a will if you don’t have one or make sure that it reflects your wishes if you do have one. I recently lost a client who had a stroke less than a year after retiring. Last time I saw her in my office, I said, “You need to marry your twenty-five-year life partner.” I recommended a will many times. 

I got the call from her partner after she died. All the beneficiary forms were in place, and the corporate pension had a certain period payment on it that protected the partner. The problem: her house, owned solely by her, was to go to her father, who happened to be spending down assets, suffering from dementia, and would likely hit a nursing home.

Get a will!

Durable Power of Attorney

Everyone should also have a durable power of attorney. This document allows someone to make decisions on your behalf and take care of your finances should you become unable to do so for yourself. It can be a general power of attorney, allowing a person to do pretty much anything you could do, or a limited power of attorney, which limits them to, say, paying the light bill.

If you don’t have a durable power of attorney and become incapacitated, a court will appoint a person. Your affairs can be contested and will become public. Don’t let this happen. Get a durable power executed and in place.

You will need a healthcare directive and a living will as well. A healthcare directive is a durable power of attorney that grants someone the power to make healthcare decisions for you should you be unable to do so for yourself. A living will documents your intentions regarding end-of-life issues.

A Tax Plan

There are two types of taxes that might need to be paid after death: estate tax and income tax.

Most people no longer face federal estate taxes thanks to recent legislation that raised the amount an individual could pass tax free to $11,580,000. It’s double for couples. In addition, a husband and wife can transfer an unlimited amount of assets to each other. Taxes will be due on the second death.

However, nineteen states have estate or inheritance taxes, some as low as $1 million. So it still may be an issue at the state level.

Any assets over the set amount are subject to an estate tax, payable by the estate. The estate is valued on the day of the person’s death, and the tax is due nine months later. 

The way to reduce estate taxes has always been to minimize one’s estate. There are several ways you can do this:

• Each person can gift $15,000 a year to as many people as they choose, without any tax implications.

• Qualified education expenses do not count as a gift for tax purposes. For example, Grandpa Tom could pay Harvard tuition for grandchildren Jane, Jennie, and John at $70,000 apiece and still gift them $15,000 each in the same year.

• Charitable contributions are fully tax deductible in the year in which the IRS deems the contributions given, subject to limits as a percentage of taxable income.

Aside from estate taxes, your heirs may need to pay income taxes when withdrawing money from yet-untaxed assets, like traditional IRAs, the investment gains in annuity contracts, and the untaxed value in employer plans. Strategies to address this include Roth conversions and life insurance to replace the income tax owed. 

For most people, this will be an issue for the next generation to figure out. Still, if splitting assets equally among children or other beneficiaries, you should consider the taxes due on certain assets to determine and adjust inheritances.

Stop Procrastinating

Too many people put off creating a will, durable power of attorney, and tax plan. “I’m not going to die tomorrow,” they think. “I still have time.” 

They keep saying that, until they run out of time. Then it’s too late. Their loved ones are left to pick up the pieces. I’ve seen too many people whose wishes weren’t honored after their death, for the simple reason that they didn’t take the time to get the right legal documents and plans in place. It’s heartbreaking every time.

Don’t wait until it’s too late. Stop procrastinating, and get a will, a durable power of attorney, and a tax plan in place now.

For more advice on financially preparing for your death, you can find Keep It Simple, Make It Big on Amazon.

Michael Lynch is a CERTIFIED FINANCIAL PLANNERTM professional with nearly twenty years of experience working with American families to craft plans that fund their dreams, educate their children, and finance their retirement. Michael has contributed to the Wall Street Journal and Investor’s Business Daily, and hosted Smart Money Radio for a decade. He’s served as an adjunct faculty member at Fairfield University and currently teaches financial planning to employees of corporations like Madison Square Garden and Yale New Haven Health Systems. Michael is a five-time Financial Planner of the Year for MetLife and a 2019 inductee to the Barnum Financial Group Hall of Fame. You can enjoy his latest articles and videos at www.michaelwlynch.com.

Representatives do not provide tax and/or legal advice. Any discussion of taxes is for general informational purposes only, does not purport to be complete or cover every situation, and should not be construed as legal, tax or accounting advice. Clients should confer with their qualified legal, tax and accounting advisors as appropriate. Securities and investment advisory services offered through qualified registered representatives of MML Investors Services, LLC. Member SIPC.  6 Corporate Drive, Shelton, CT 06484, Tel: 203-513-6000. CRN202210-272633

Keeping the Home

For most Americans, home is not only where the heart is, it’s where the money is as well.  It’s little wonder then that a leading concern of many people seeking advice from financial professionals centers on issues of housing. 

For our young clients, the issues are: How much can we afford? How soon can we buy? What’s the best kind of mortgage? 

More mature clients often focus on another pressing issue: How can we protect our home and pass it or its value to the next generation regardless of whether we get sick and need expensive long-term care services?   

Fortunately, there are ways for seniors to plan that may protect the value of their homes and ensure passage to the next generation, should that be a goal. Some are easy and obvious, and some a big more complicated. They all take a bit of effort. Nothing happens in life unless one makes it happen. Each requires time to complete, anywhere from a few months to five years. So the sooner one moves the better. They all involve using some combination of gifting, insurance, trusts, and family. 

First a bit of background. The average net worth of Americans ages 65 to 74 is $190,000. Nearly seven in ten own a house, the average value of which is $150,000. (Source: Federal Reserve Board, Survey of Consumer Finances, 2004) 

The American dream starts at home. The threat is the cost of nursing home care. We are living longer. A married couple that celebrates each other’s 65 birthday has a 60 percent chance that one will be blowing out 90 candles on a cake. (U.S. Census Bureau) When we live this long, we often need help. And help is expensive. In Connecticut, average home care costs $25 an hour.  Assisted Living is at least $3,500 a month. Nursing home care tops $300 a day. (Source: MetLife Mature Market Institute 2007)

The nursing home bill is often first paid from income, then bank accounts, then other countable assets have to be liquidated and finally the state, if needed.  In Connecticut, the average nursing home resident is a single woman at least 85 years-old on state support. (Source: State of Connecticut Annual Nursing Facility Census, September 30, 2007) This means she has $1,600 or less to her name.

So how can we protect our homes? While the home, assuming the nursing home patient states an intention to return to that home, is not a countable assets and thus will not prevent the nursing home patient from receiving Medicaid.  Upon the death of the nursing home resident, however, his or her home may be subject to a lien equal to the value of services they received through Medicaid.   So you may not only have to remove the house from your name, but you also have to keep the house out of the reach of the estate recovery rules.  This is not so simple to achieve, and any attempt to accomplish either has tax and ownership consequences that should be discussed with a qualified Medicaid planning attorney.   

This column will focus on a strategy that uses a “life estate.”  Property rights are typically a bundle of rights that can be split and divided, and the rights to a home are no different.  If a person wants to transfer their home—removing it from their ownership—but retain the ability to live in it forever, considering a life estate strategy is a good idea. 

Essentially, this strategy divides the value of a home into two parts. The use value of the right to live in the house for a number of years, demarcated by a person’s life expectancy, and the remainder value after the person has passed on. The remainder value is transferred to a person, while the owner of the house retains the life estate. For Medicaid purposes, this is considered a transfer of assets, and is therefore subject to a 60 month look back rule. As a result, the sooner one takes action the better, as in so many things financial.  For Medicaid recovery purposes, many states, including Connecticut, currently limited the assets available for recovery to probate assets.  That is assets that pass through the probate process.  A life estate passes by operation of law (outside of probate) to the remainder beneficiary.  Thus in many cases the home that is subject to a life estate will not be available for estate recovery.  (Caution - federal law does authorize these states to expand their definition of available assets to include any asset in which the decedent has any interest.  Several states have expanded their definition of available assets to include property subject to a life estate.) 

Here’s some real numbers. An 85 year old woman with a house valued at $250,000. The value of her life estate is $43,524. The remainder value is $206,476. If she puts a life estate on the deed, she effectively transfers $206,476 of value for Medicaid purposes, while retaining the right to live in the house for the rest of her life. For estate tax purposes, the entire value of the house will be included in the woman’s estate. This means that although values over $1 million are subject to Connecticut estate tax and over $2 million are subject to federal estate tax, the house receives a step up in basis at death. For modest sized estates in which the house is the major asset, this is a great advantage. 

As you can see, there are real actions middle class people can take to protect the value of the home they have spent their lives building, improving, and paying off. This requires a bit of vision, planning, time, and the use of qualified professionals.  In recent years the Medicaid laws have undergone a number of changes.  Certain planning vehicles have been eliminated and most rules have been tightened.  It is reasonable to expect that further changes will occur.  It is vital that you speak with a local attorney with much experience in Medicaid planning. The first step in all things financial is to dream big dreams and set clear goals, in this case protecting the value of the family home. Then contact a professional, explore your options and get the process started. 

Mike Lynch CFP® is a senior financial planner at the Barnum Financial Group, an office of MetLife, in Shelton. He co-hosts Smart Money Radio on WICC, 600 AM on Saturdays from 10 a.m. to noon. He can be reached at mlynch1@metlife.com or 203-513-6032.

You Need Life Insurance

The following is adapted from Keep It Simple, Make It Big.

If someone you love depends on you or your income, chances are you need life insurance.

From the start of your working years to the end of your life, life insurance serves an important purpose.

Early in life, when mortgages are large, children need to be educated, and retirement plans are in the building stage, life insurance funds these unfunded liabilities should something happen to a breadwinner. It allows a family to accomplish its goals.

Later in life, the focus shifts to protecting the assets one has acquired. Should a spouse die, life insurance can make up for the loss of a pension, reduced Social Security payment, the depletion of investments for long-term care services, and more. 

We must protect that which we can least afford to lose. So no matter your age, you need life insurance to take care of your loved ones should you pass.

How Much Life Insurance Do You Need?

There are various rules of thumb about how much life insurance you need—such as two times, ten times, or twenty times salary—but everyone’s needs are unique. It’s best to do your own personal math.

There are two basic methods of calculating how much life insurance you need. 

The first is referred to as the human life value. This straightforward method simply figures what a person would earn until retirement, subtracts out taxes and what the person would consume, and then figures out how much money that would be in current dollars.

The second approach is often called a basic needs analysis. This method examines the actual expenses that would be involved if one died, the things a family would want to take care of, such as education for the children, paying off mortgages and other debts, and income replacement. It then calculates a figure based on these basic needs.

If a family is living on 100 percent of their income, which is often the case, these two approaches will produce similar results. One difference is that expected future salary increases can be built into a human life calculation. 

The value of one’s services must be protected as well. When a primary earner dies, income needs to be replaced but expenses will generally go down. When a homemaker dies, though, expenses will increase, due to the need for things like childcare.

For retirees, the focus is on replacing income that will be lost, such as Social Security and pension. Wealth replacement is also an issue. If a long-term care need strikes, assets earmarked for income may have to be expended. A prudent life insurance program can replace this wealth when a person passes away.

The Types of Life Insurance 

Insurance comes with many features and many names, but there are two fundamental types: temporary and permanent.

Temporary Insurance

Temporary insurance is called term insurance. These contracts cover a person for a set number of years: one, ten, fifteen, twenty, and thirty. It can have adjustable premiums or level premiums over a period and then adjust. It is pure insurance, like auto and home. If you don’t get unlucky and use it, there is no residual value.

Over the last few decades, it has consistently gotten better and cheaper. If you are healthy, you can now purchase term that does not expire until you are in your eighties.

As with anything, term life has advantages and disadvantages. The primary advantage is price. Young healthy people can purchase big blocks of insurance for low premiums. It allows young families to cover temporary needs with temporary insurance. 

The primary disadvantage is that premiums increase over time, which makes it unaffordable for older people. Each contract term has a level premium, but one will likely outlive this contract and then face higher prices. This means that very few policies pay a death benefit, roughly 1 percent. If a family has permanent needs, this will not provide the protection it needs.

If you obtain life insurance through your employer, it is most likely group term. The advantages are that it’s easy to get in open enrollment, and the premiums can be fairly inexpensive. However, the disadvantages are that an employer usually does not offer enough face amount to cover a person’s need, and the insurance is usually not portable at low prices. Changing jobs means changing insurance or losing insurance. 

Permanent Insurance

Permanent insurance is designed to last a person’s lifetime and ultimately pay a death benefit. It combines term insurance with an investment account in which premiums grow on a tax-free basis. 

These cash values are owned by the contract owner and can be accessed for use while the person is alive for such things as college funding, cash reserve, and retirement funding. Some policies allow the cash to be accessed as a withdrawal of premium. Others require the cash to be loaned.

Permanent policies differ based on how the cash value is invested, who controls the investment, whether the premiums are flexible or fixed, and whether the death benefit is flexible or fixed.

Whole life is the name for traditional permanent life insurance. The cash values are invested by the insurance company in its general account, which is comprised mostly of fixed-income investments. Premiums are fixed, as is the death benefit. Participating policies will pay dividends that can be used to offset premiums or purchase additional insurance.

Universal life policies are similar to whole life in that the cash value of this policy is invested conservatively by the insurance company. It differs from whole life in that it never pays dividends. Its premiums are flexible as is its death benefit. Modern contracts can offer lifetime guarantees for death benefit regardless of cash value.

Variable universal life is a contract in which the cash value is invested by the contract owner in variable subaccounts that provide access to professional money managers. These are generally equity, fixed income, and a guaranteed interest account. Premiums are flexible as is the death benefit. Some modern contracts offer guarantees for death benefit that are not dependent on cash values.

Survivorship policies, often called “joint life” or “second to die” policies, are single contracts that cover two lives and pay a single benefit upon the second death. They are permanent contracts and can be whole life, universal life, or variable universal life. 

Choosing the Life Insurance Right for You

There is no “best” life insurance contract or type. The type that best fits a family’s needs will depend on many factors. 

Start by calculating the amount of life insurance you need, and then look at your various options. It can be worth consulting a professional.

Everyone should think of life insurance as a necessary expense. There are some risks in life that simply can’t be invested for; they must be insured against. 

It’s far better to have life insurance and not need it, than to need it and not have it. With life insurance, you can ensure that your loved ones are financially taken care of after you’re gone.

For more advice on life insurance, you can find Keep It Simple, Make It Big on Amazon.

Michael Lynch is a CERTIFIED FINANCIAL PLANNERTM professional with nearly twenty years of experience working with American families to craft plans that fund their dreams, educate their children, and finance their retirement. Michael has contributed to the Wall Street Journal and Investor’s Business Daily, and hosted Smart Money Radio for a decade. He’s served as an adjunct faculty member at Fairfield University and currently teaches financial planning to employees of corporations like Madison Square Garden and Yale New Haven Health Systems. Michael is a five-time Financial Planner of the Year for MetLife and a 2019 inductee to the Barnum Financial Group Hall of Fame. You can enjoy his latest articles and videos at www.michaelwlynch.com.

Representatives do not provide tax and/or legal advice. Any discussion of taxes is for general informational purposes only, does not purport to be complete or cover every situation, and should not be construed as legal, tax or accounting advice. Clients should confer with their qualified legal, tax and accounting advisors as appropriate. Securities and investment advisory services offered through qualified registered representatives of MML Investors Services, LLC. Member SIPC.  6 Corporate Drive, Shelton, CT 06484, Tel: 203-513-6000. CRN202210-272635