Life Insurance Analysis

While you are working

How much coverage, and why multiples of income are the wrong tool

The common rule is ten times income, sometimes twelve. It is easy to say, and it ignores the pension and the assets already in place. It is the wrong tool for a household with a pension and a substantial balance, because it ignores everything that household has already built.

The method that answers the question is a subtraction, not a multiplication. Start with what the survivor would actually need each year. Take away what arrives without you: their own income, the pension survivor benefit under the option you elected, and Social Security. Whatever is left is the annual gap. Work out the capital required to fund that gap for as long as it runs, add the one-time costs that fall due at death, then subtract the savings and the coverage already in force. What remains is the need.

Run that way, the answer for a well-pensioned household can be far smaller than a multiple of income suggests, and can be zero. That is a real answer and it is worth getting before anyone shows you a product.

Calculator. Work out how much coverage the household actually needs. It subtracts the pension survivor benefit, Social Security, the survivor’s own income, your savings and the insurance already in force, and it returns zero when zero is the answer.

Two cautions about any needs figure, including the one that calculator produces. Retirement accounts are counted at face value, and a survivor drawing on a pre-tax account pays income tax on the way out, so the real resource is smaller than the balance. And the capital figure is sensitive to the real return assumed on the money; moving that assumption by one percentage point moves the answer substantially, which is a reason to treat any single number as a range.

One New Jersey reason the answer may not be zero

The subtraction above is unsentimental, and for a household with a pension and a large balance it can return nothing. There is one New Jersey circumstance where it returns nothing and is still the wrong answer, because the need has nothing to do with replacing anyone’s income.

New Jersey charges inheritance tax by who receives the money rather than by the size of the estate. A spouse, child, grandchild, parent or stepchild pays nothing. A sibling or a child-in-law is Class C and is taxed above a $25,000 exemption. A niece, a nephew, a cousin, a friend or an unmarried partner is Class D and is taxed from close to the first dollar, at 11% to 16%.

Life insurance is carved out of it. In the words of the Division of Taxation, the proceeds of any contract of insurance insuring the life of a resident or nonresident decedent paid or payable, by reason of the death of such decedent, to one or more named beneficiaries other than the estate, executor or administrator of such decedent are exempt for New Jersey Inheritance Tax purposes.

So if you intend to leave anything to someone outside Class A, the coverage question is not how much income needs replacing. It is how much of what you intend to leave would be taken on the way there, and whether you would rather pass that part through a policy, where it arrives whole. That is a one-time amount rather than an annual gap, so it belongs in the one-time costs field of the calculator above rather than in the yearly need.

The exception inside the exemption is easy to get wrong and expensive when it happens: it covers proceeds paid to a named beneficiary, not proceeds payable to the estate or the executor. A designation that is stale, blank, or says “my estate” turns an exempt payment into a taxable one. The mechanics are set out below.

Term or permanent, for this particular job

The two are not competing versions of the same product. They answer different questions, and confusing the two is costly.

	Term	Permanent
What it is for	A defined period of exposure: working years, a mortgage, children at home, a deferred compensation schedule that has not finished paying.	A need that does not end: estate liquidity, a special needs beneficiary, a buy-sell obligation, a survivor who will always be short.
Cost for the same death benefit	A fraction of the permanent premium.	Several times the term premium, because part of it funds cash value and the cost of insuring you for life.
What happens at the end	It expires. If the need also expired, nothing has been lost.	It pays, provided it stayed in force, which is the whole question.

The ordering for a household with a pension and a large balance: term covers the working-years exposure, and permanent is worth discussing only when there is a need that genuinely does not end. When the case for permanent rests on the tax treatment rather than on a permanent need, read what is actually true about that tax treatment below, before going further.

A note on the middle ground. Term policies can include a conversion privilege that lets you exchange the policy for permanent coverage without new underwriting, within a stated window. That option has real value if your health changes, and it costs nothing while it sits unused. It is worth knowing whether your policy has one and when it expires, because it is the cheapest insurance against becoming uninsurable.

What your group coverage actually gives you

Coverage at work is the first number to count, not the last. It is worth counting, and it is worth knowing its three limits before you rely on it.

• It ends when the employment ends, unless converted or ported. That includes retirement, and it includes the moment a serious illness stops you working, which can be when the coverage is needed most and when replacing it is hardest.
• It is a multiple of salary, set by the plan, not by your household. Against the subtraction above, that can be a small fraction of the gap.
• Above $50,000 it is not free. Under section 79 of the Internal Revenue Code the cost of the first $50,000 of employer-provided group-term life is excluded from your income, and the cost of coverage above that is included. It appears on your W-2 as imputed income. The amount is small, but it means the coverage is not the pure benefit it looks like, and it is worth knowing what you are being taxed on.

Supplemental coverage offered through the employer is sometimes priced well and sometimes priced worse than an individual policy you own, particularly if you are in good health. It is worth one comparison rather than an assumption in either direction.

While you are still working, the income is the asset

For a household in its peak earning years the largest asset may not be on any statement. Someone earning $400,000 at 52 with thirteen working years ahead is carrying several million dollars of future earnings, and every plan the household has quietly assumes those earnings arrive. This is the period when coverage does the most work and costs the least, and it is also the period to look past what the employer provides.

Senior compensation makes the exposure larger than the salary suggests, because two of its largest components do not survive you: equity that has not vested generally does not pay out to your family, and a non-qualified deferred compensation balance is an unsecured promise on a schedule chosen years ago that does not move because a family needs the money sooner. The executive page works through both.

The risk that is larger during working years

During the years the income is the asset, the more probable threat to it is not death but an illness or injury that stops you working. Disability coverage is the less interesting product and can be the more important one, and it is worth getting right before anyone discusses life insurance as a savings vehicle.

The point that catches people. A group long-term disability policy that promises 60% of salary does not deliver 60% when the employer paid the premium. Under section 105(a) of the Internal Revenue Code, amounts received through accident or health insurance are included in gross income to the extent they are attributable to employer contributions that were not included in the employee’s income, or are paid by the employer. Benefits attributable to premiums you paid yourself with after-tax dollars are excluded instead. So the employer-paid policy pays a taxable benefit and the one you funded yourself pays a tax-free one, which can be the difference between a replacement ratio that works and one that does not. Where the employer offers the choice, paying the premium yourself can be the better arrangement. Ask whether you have it.

Two other terms decide whether the policy pays at all: whether it defines disability as being unable to perform your own occupation or any occupation, and whether the benefit stops at a stated dollar cap that a high earner reaches long before 60% of actual income. Both are in the certificate rather than the brochure.

Underwriting, and why the time to buy is before you need it

Insurance is priced on your health at application, and the price is locked for the life of the policy. That has one practical consequence worth stating plainly: coverage bought while you are healthy and do not urgently need it is cheap, and coverage sought after a diagnosis is expensive or unavailable. This is the one respect in which the industry’s urgency is not manufactured.

It also means an illustration is not an offer. A proposal built on a preferred rate is a proposal only once underwriting has confirmed you qualify for it, and rates can come back rated or declined for things you do not think of as serious. Nothing that depends on the coverage existing, a pension election in particular, should be decided until the offer is in writing.

---

Rather go through this with your own numbers? We can cover it in a short conversation, at no charge and with no obligation. Book your Life Insurance Review

Later uses

The four rules everything else rests on

Four provisions sit behind the tax treatment of life insurance. They are short, and knowing them lets you test what you are told.

The rule	What it says	What it means in practice
Section 101(a)(1)	Gross income does not include amounts received under a life insurance contract, if such amounts are paid by reason of the death of the insured.	The death benefit is not income to your beneficiary. This is the real advantage and it is unconditional. It is also the only one on this list that has no catch.
Section 2042	The gross estate includes proceeds receivable by the executor, and proceeds receivable by anyone else where the decedent possessed at his death any of the incidents of ownership.	Not income tax and estate tax are different questions. A policy you own is in your taxable estate even though the money never passes through probate. This is the point almost everyone gets wrong.
Section 2035(a)	Property transferred within three years of death is pulled back into the gross estate, and the statute specifically declines to exempt transfers with respect to a life insurance policy.	Giving away a policy you already own does not work if you die within three years. A trust that buys a new policy from the start is not caught by this. The difference is worth a great deal of money.
Section 72(e)	Amounts taken from a life insurance contract are included in income only to the extent they exceed the investment in the contract. For a modified endowment contract, the income comes out first instead.	Withdrawals up to what you paid in come out tax free, unless the policy was funded fast enough to become a modified endowment contract, at which point the ordering flips permanently and loans count as distributions too.

Paying an estate tax bill without selling the house

New Jersey repealed its estate tax, so for most households the relevant question is the inheritance tax, which is covered in the next section and on the inheritance tax page. The federal estate tax still applies above the federal exclusion, and for a household with a business, a practice, or significant real estate the same liquidity problem arises.

The problem is liquidity, not the rate. It is that the tax is due in cash, generally nine months after death, and the estate is not cash. It can be a house, retirement accounts that are taxed again on the way out, and sometimes a business or a second property. None of those can be turned into money in nine months without selling into a deadline, which is the worst condition under which to sell anything.

A death benefit arrives as cash, at the moment the bill arrives, and is not income to the person who receives it. That is the entire case, and it is a good one. The difficulty is the second rule in the table above: if you own the policy, the death benefit is added to the estate it was bought to pay tax on. A $2,000,000 policy bought to cover the tax increases the taxable estate by $2,000,000.

What an irrevocable life insurance trust actually does

The trust, not you, owns the policy and is its beneficiary. You never hold an incident of ownership, so section 2042 does not reach the proceeds, and the trust has cash on the day the estate has a bill. Nothing about this is exotic. It is the standard answer and has been for decades.

It is also easy to set up badly. Three things decide whether it works:

• The trust should buy the policy, not receive it. Moving an existing policy into a trust starts a three-year clock under section 2035(a), and the statute goes out of its way to say life insurance does not get the exception that other small transfers get. A trust that applies for and owns the policy from the beginning never has this problem.
• The premiums have to get into the trust properly. Money you give the trust each year to pay premiums is a gift, and the machinery for making those gifts qualify for the annual exclusion involves written notices to the beneficiaries. This is administrative work that has to actually happen every year, and it is the part that quietly stops happening.
• Irrevocable means irrevocable. You cannot change your mind, take the cash value back, or borrow from it. That is the price of keeping it out of the estate, and for a household whose situation may change it is a real cost rather than a technicality.

When this is not the answer. If your estate is comfortably below the threshold and likely to stay there, this solves a problem you do not have, and the premiums are simply a cost. The honest first step is to price the actual exposure before anyone discusses a policy size. If the projected tax is zero, the conversation is over.

The one place New Jersey treats insurance better than anything else

This is the most useful thing on this page for a New Jersey household.

New Jersey inheritance tax is charged by who receives the money, not by how large the estate is. Class A beneficiaries, meaning a spouse, child, grandchild, parent or stepchild, pay nothing. A sibling or a child-in-law is Class C and is taxed above a $25,000 exemption. Everyone else, which includes a niece, a nephew, a cousin, a friend or an unmarried partner, is Class D and is taxed from close to the first dollar, at 11% to 16%.

Life insurance is carved out of this entirely. In the words of the Division of Taxation, the proceeds of any contract of insurance insuring the life of a resident or nonresident decedent paid or payable, by reason of the death of such decedent, to one or more named beneficiaries other than the estate, executor or administrator of such decedent are exempt for New Jersey Inheritance Tax purposes.

Read the exception carefully, because it is where this goes wrong. The exemption applies to proceeds paid to a named beneficiary. Proceeds payable to the estate, the executor or the administrator are outside it. A policy whose beneficiary designation is stale, or blank, or says “my estate,” can convert an exempt payment into a taxable one. That is a five-minute check on a form.

The practical consequence: if you intend to leave money to anyone outside Class A, a dollar passed through a life insurance policy to a named beneficiary arrives whole, while a dollar passed through the will arrives with 11% to 16% removed. That is not a sales argument about returns. It is a feature of the statute.

Pension maximization, and the four ways it fails

The idea. At retirement you choose between the largest pension, paid only while you are alive, and a smaller one that continues to your spouse. The gap between them is the cost of the survivor benefit. The proposal is that you take the larger pension, buy life insurance on yourself with part of the difference, and leave your spouse better off, with a death benefit instead of a continuing pension.

Sometimes the arithmetic supports this and sometimes it does not. Four things decide whether the comparison is sound.

• The pension election is irreversible and the policy is not. In New Jersey, once the retirement is due and payable the option cannot be changed, and under Options A through D the beneficiary can never be changed. The insurance company, by contrast, can raise the cost of insurance inside a policy that is not guaranteed, and you can miss a premium. You are trading a guarantee that lasts as long as your spouse lives for an obligation you have to keep funding.
• Lapse is not a small risk over thirty years. The policy must be in force on the day you die, which may be decades after anyone remembers why it was bought. A policy that lapses at 84 leaves the survivor with no pension and no death benefit. If this arrangement is used at all, the coverage should be guaranteed for life rather than projected to last, and the difference between those two words is the whole question.
• Survivor health coverage can be tied to the pension election. In some public and private plans a surviving spouse keeps retiree medical coverage only if a survivor annuity is payable. A death benefit does not replace that, and the cost of replacing the coverage can exceed everything the strategy saved. This is employer-specific and has to be confirmed in writing with your own plan before anything is elected.
• Insurability is tested at the worst moment. The strategy only works if you can actually buy the coverage at the price in the illustration, and underwriting happens in your late fifties or sixties. A proposal built on a preferred rate that you do not qualify for is not a proposal. The offer has to be in hand, in writing, before the pension option is elected, not after.

How to test it honestly. Price the survivor option gap in real dollars a year using your own benefit estimates. Get an actual underwriting decision, not an illustration, on a guaranteed policy for a death benefit large enough to fund the survivor’s income for their whole life expectancy rather than a round number. Confirm the health coverage question in writing. Then compare a guaranteed pension against a guaranteed premium. If anyone shows you this comparison using a projected policy value rather than a guaranteed one, the comparison is not the one you need.

Permanent policies, and what is actually true about the tax treatment

Permanent insurance can be presented as a tax-advantaged place to accumulate money. Parts of that are accurate, and the parts below are what decide whether it works for a particular household.

What is true

• The death benefit is not income to the beneficiary. Section 101(a)(1), unconditionally.
• Cash value grows without annual taxation. There is no 1099 each year.
• Withdrawals up to the amount you have paid in are recovered first and are not taxed, because section 72(e) includes amounts in income only to the extent they exceed the investment in the contract.
• A policy loan is not a distribution while the policy stays in force, which is the mechanism behind tax-free access.

What tends to be left out

• The cost of insurance rises every year and is deducted from the cash value. In the early years a large share of what you pay is not invested at all. This is why the first several years of cash value are far below what was paid in, and why surrendering early is expensive.
• The illustrated rate is not a return. An illustration is an arithmetic projection at an assumed rate, not a forecast and not a promise. The guaranteed column is the one that binds. Ask for it, read it, and if it is not offered, that is the answer.
• A lapsed policy with a loan against it produces a tax bill. If the policy ends while a loan is outstanding, the forgiven loan is treated as income, and it can arrive in a year when there is no cash to pay it. This is the failure mode of the borrow-against-your-policy strategy. Ask to see it.
• Funding it quickly can break the tax treatment permanently. A contract that fails the seven-pay test in section 7702A becomes a modified endowment contract. The income then comes out first instead of the basis, and loans are treated as distributions rather than as loans. The classification cannot be undone afterward.

The test that settles it. Would you buy this if the tax treatment were ordinary? If the answer is yes, because the household needs a death benefit that lasts for life and the premium is affordable forever, then the tax treatment is a genuine advantage on top of a decision that already made sense. If the answer is no, and the case rests entirely on the tax wrapper, you are being sold a tax structure with an insurance policy attached, and a cheaper way to get the same tax result may exist.

Using cash value for supplemental retirement income

There is one use of a permanent policy that is about accumulation rather than protection, and it is the reason a household that does not need a death benefit at all might still look at one. A policy can be funded well above what the insurance itself costs. The excess builds cash value, and that cash value is not taxed as it grows. Later, it can be taken out in a sequence that produces no taxable income: withdrawals first, up to the total of what was paid in, then policy loans against what is left.

The sequence is statutory rather than promotional, and it is worth seeing where each step comes from. Section 72(e)(5)(C) applies the ordinary rule to amounts not received as an annuity under a life insurance contract. Section 72(e)(5)(A)(ii) then includes such an amount in income only to the extent it exceeds the investment in the contract, which is what puts your own money first. Section 72(e)(5)(A)(i) switches off paragraph (4)(A), the rule that would otherwise treat a loan as an amount received, which is why a loan against a policy that stays in force is not a distribution. And whatever death benefit remains is excluded from the beneficiary’s income under section 101(a)(1). Each of those is a real provision, and each one has a condition attached that the next section sets out.

Who this is for is a specific person: someone who has already taken the full employer match, filled the 401(k) or 403(b), used a Roth or a backdoor Roth where it is available, funded a health savings account if eligible, holds a cash reserve, and still has income left to put away. That household has run out of tax-advantaged room. The usual next stop is a taxable brokerage account, which is taxed on dividends every year and on gains when positions are sold. Cash value is one of the few remaining places with no annual contribution limit and no income phase-out, which is the entire reason it is worth the complexity for that reader and not worth it for anyone earlier in the order.

What it does that the alternatives do not	Where that comes from
No annual contribution limit, and no income phase-out. What you can put in is limited by the contract and by the seven-pay test, not by a statutory deferral cap or by how much you earn.	A consequence of what the contract is. Compare the elective deferral limit on a 401(k) and the income phase-out on a Roth IRA.
Nothing forces income out at any age. There is no lifetime required minimum distribution, so the account is not obliged to generate taxable income in a year you did not want it.	Section 401(a)(9) conditions a trust forming part of an employer plan, and individual retirement accounts pick the rule up separately. A life insurance contract is neither.
No age restriction on getting at it. Access does not wait for 59 and a half, which matters for someone planning to stop working early.	The 10% additional tax in section 72(t)(1) applies to an amount received from a “qualified retirement plan (as defined in section 4974(c)).” A life insurance contract is not one.
Income taken this way does not show up in the two thresholds that quietly tax retirees twice: the share of Social Security that becomes taxable, and the Medicare surcharge. An amount that is not includible never reaches adjusted gross income in the first place.	The Social Security calculation in section 86(b)(2) and the Medicare surcharge in 42 U.S.C. 1395r(i)(4) both start from adjusted gross income and add back only tax-exempt interest. Neither adds back a non-taxable policy withdrawal or a policy loan. See Medicare and IRMAA.
What is left over passes to the beneficiary without income tax, rather than arriving as a taxable account someone has to draw down.	Section 101(a)(1). A pre-tax retirement account does the opposite: it reaches the beneficiary as income in respect of a decedent.

What has to be true for it to work

• It has to be funded near the limit, with the smallest death benefit the contract allows for that premium. The cost of the insurance is deducted from the same account that is supposed to be accumulating, so a larger death benefit sounds more generous and leaves less money working. A policy sold on the size of its death benefit is not the policy that does this job.
• The funding has to stop short of the seven-pay test. Overfunding is the entire mechanism, and overfunding past the line in section 7702A is what destroys it. A contract that fails the test becomes a modified endowment contract, and section 72(e)(10)(A) then reverses both of the rules this strategy depends on: income comes out first, and loans are treated as distributions. That change is permanent. The funding limit is therefore not a guideline.
• Fifteen years at least, and realistically longer. The early years are expensive and the cash value sits below what has been paid in for some time. A short horizon does not produce a result worth the trouble.
• The premium has to be genuinely affordable for decades. This is a commitment, not a contribution you can skip in a bad year. A policy funded for three years and then abandoned is the worst version of this.
• The plan has to survive the guaranteed column. Run the whole thing at the guaranteed rate rather than the illustrated one and see whether it still does what you wanted. If it only works at the illustrated rate, it does not work.
• It comes last. Not before the match, not before the qualified space, not before an emergency reserve, and not instead of term coverage if the household still has a protection gap. The sizing half at the top of this page answers that question first for a reason.

The failure mode deserves its own sentence, because it is the one that turns this from a reasonable idea into a genuinely bad outcome. If the policy lapses or is surrendered while a loan is outstanding, the loan is treated as received at that moment and the gain becomes income, and it can be income with no cash attached to pay the tax on it. That is not an edge case. It is what happens when a policy is borrowed against for years and nobody checks whether it is still funded well enough to stay in force. Managing this means reviewing the policy every year for as long as you hold it, which is a real obligation and should be priced into the decision rather than discovered later.

None of the above makes this the right answer. It makes it a real option with a narrow set of conditions attached, which is a different claim. For a household that has filled every other tax-advantaged account, has a long horizon and steady income, and reads the guaranteed column before agreeing to anything, it does something a brokerage account cannot. For anyone who does not meet those conditions, the honest answer is a term policy for the protection gap and an index fund for the savings.

Long-term care, and the hybrid policies

Section 101(g) of the Internal Revenue Code allows a policy to pay benefits before death, tax free, to someone who is terminally or chronically ill, where the payments for a chronically ill insured cover the cost of qualified long-term care services. That provision sits underneath the hybrid policies now sold widely, which combine a death benefit with a long-term care benefit drawn from it.

The tradeoff, stated honestly. Standalone long-term care insurance buys more benefit per dollar, and if care is never needed the premiums are gone, which is the objection people actually have. A hybrid pays something either way, which is what makes it easier to buy, and you pay for that certainty with a smaller benefit for the same money. Neither is a trick. Which fits depends on whether the household could fund a few years of care out of its own assets without damaging the survivor, and that is an arithmetic question before it is a product question.

Business owners: the two uses, and the trap inside one of them

See also the business owners page.

• Buy-sell funding. An agreement that says the surviving owners will buy the deceased owner’s share is worth what the money behind it is worth. Insurance is the usual funding. Without it the agreement obliges the survivors to find a large sum at the worst moment, and the family of the deceased owner is the one who bears the failure.
• Key person coverage. The business, rather than the family, is the beneficiary, and the proceeds cover the revenue and the disruption that follow losing someone the business depends on. Premiums are not deductible, which is a frequent surprise.

The trap. Section 101(a)(2) is the transfer-for-value rule. If a policy is transferred for valuable consideration, the income tax exclusion on the death benefit is cut back to the consideration paid plus premiums paid afterward. In other words, the tax-free death benefit stops being tax free. This is easy to trigger by accident when a buy-sell arrangement is restructured and owners swap policies on each other. The statute names exceptions, including a transfer to the insured, to a partner of the insured, to a partnership in which the insured is a partner, or to a corporation in which the insured is a shareholder or officer, and those exceptions are the reason the structure of the agreement has to be settled before any policy changes hands. Restructuring a funded buy-sell without checking this is one of the more expensive unforced errors available to a private company.