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Supplemental Life Insurance
Supplemental life insurance is additional insurance bought by a current policyholder. The purpose in acquiring additional insurance is to increase coverage, either because the insurance need has increased or because it has changed in scope. Supplemental life insurance will often be purchased under a provision in the existing policy that allows it.
Reasons for Acquiring Supplemental Life Insurance
There are many possible reasons why an existing insurance policyholder might wish to increase the amount of insurance held. Since a basic purpose for buying insurance is to protect dependents from loss of income due to death of the breadwinner, an increase in the size of the family will logically motivate an increase in insurance protection. The more dependents, the larger the replacement income will need to be, since the arrival of each child will be accompanied by education expenses and larger living expenses. This will necessitate an increase in coverage. Likewise, an increase in medical expenses or indebtedness will require a commensurate increase in insurance coverage.
The more the scope of the life insurance increases, the greater will be the demand for supplemental life insurance coverage. Shifting the focus from meeting insurance needs to providing additional retirement income actually provides additional reasons to consider supplemental life insurance.
Details of Acquiring Supplemental Life Insurance
Many life-insurance policies anticipate the need for supplemental insurance coverage through a provision guaranteeing its availability in a specified form. The specifications dictate the type and amount of supplemental insurance that can be acquired without writing a new policy. Depending on the contract, the supplemental insurance may be term, whole life or some other variant. There will probably be a maximum amount obtainable and there may be a minimum purchase as well.
The amounts are usually expressed as a multiple of the insured’s current salary. This is more flexible than specifying an absolute amount, since the dollar insurance need will vary widely depending on salary and standard of living. It is common for the amount of supplemental insurance to be automatically – and substantially – reduced at age 65. Other common features of supplemental insurance include an accelerated death benefit that pays all or part of the death benefit in advance of death when the insured becomes terminally ill, and a proviso that the policy will pay premiums if the insured becomes disabled. The insured may need to qualify for additional insurance by demonstrating evidence of insurability, or medical fitness, and may also need to show ability to pay for the supplemental insurance.
Supplemental insurance provisions frequently appear in group life insurance policies. These policies often allow the insured to convert to an individual policy at retirement without showing evidence of insurability.
If the existing policy makes no provision for supplemental insurance, the insured will have to qualify for and acquire additional insurance through the normal process, either with the current company or a new insurance provider.
Suitable Candidates for Supplemental Life Insurance
The foregoing provides one profile of a candidate for supplementary life insurance – an individual or household whose insurance need has increased. Although the most common scenario for this profile is a young and growing family of moderate means, it might appear in any demographic group.
An entirely different scenario is illustrated by another candidate group – a well-off household nearing retirement. Here, the main motivation for acquiring supplemental life insurance is not insurance need, although that would make the purchase even more attractive. Rather, the purpose is to take advantage of the tax-deferral and tax-avoidance properties of life insurance in order to supplement retirement wealth and income.
The supplementary life insurance vehicle of choice is universal variable life insurance or indexed universal life insurance. Universal insurance possesses maximum flexibility in premium payment; variable and indexed products provide maximum investment-growth potential for increasing cash value. By purchasing either of these universal life insurance products, the would-be retirees gain tax-deferral on their cash-value investment. This is very useful for a high-income household badly in need of tax shelter but facing contribution limits to qualified plans. No such limits hinder universal insurance policyholders, nor is there a requirement to begin taking distributions at age 70 ½. The IRS penalty on premature withdrawals prior to age 59 ½ also does not normally apply.
Universal life insurance allows the “overfunding” of a life insurance policy, just as it makes it possible for lower-income families to “underpay” premiums in order to fulfill increased life-insurance need. The overfunding will promote cash-value growth that can be tapped via tax-free policy withdrawals and/or loans. (The policy is “overfunded” relative to actual life-insurance needs, but it should not be overfunded relative to IRS strictures on modified endowment contracts, whose tax benefits are more limited.) A further inducement of this strategy is the total-disability benefit rider that is commonly available to policyholders as a means of insuring against loss of earned income prior to retirement.
This strategy of using supplemental life insurance to create additional retirement income comes complete with a set of cautionary rules. In addition to restricting premium payments enough to avoid being declared a modified investment contract, the policyholders should plan to make contributions for at least 10 years. This should enable them to avoid paying the surrender charges that commonly accompany this particular policy. They should avoid allowing the policy to lapse, which will not only kill its benefits but also make all outstanding loans taxable. They should remember that the policy’s death benefit will be reduced by the amount of withdrawals and loans outstanding at death. This death benefit, while income-tax-free to beneficiaries, will be included in the deceased’s estate, which might well subject it to estate taxation.
Supplemental life insurance is a valuable consideration not only to those whose insurance need has grown but also to households nearing retirement. This means that it can improve the lives of low-, moderate- and high-income individuals and families. Term, whole-life and universal insurance may each play a role in this process, depending on the particular circumstances involved.
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