How to avoid taxes when buying life insurance for parents

How Buying Life Insurance for Parents Benefits You

Buying life insurance for parents can be a great way to help protect yourself financially. Many adults find themselves caring for an aging loved one at some point in their lives, but the associated costs of long-term elderly care can be daunting, potentially throwing your own retirement and savings goals off track. Here’s everything you need to know about buying life insurance for parents so your own finances don’t suffer.

Can I Buy Life Insurance for My Parents?

Before you can decide which type of insurance to buy for your parents (or if you even need insurance for them), you need to know if you’re eligible to purchase a policy for your parents. Here are the 2 required criteria:

  1. You have to be able to prove your finances will be negatively impacted by a parents death. 
  2. You have to have the written consent of the parent you’re trying to insure.

In most cases, it isn’t difficult to prove your finances will be negatively impacted by the death of a parent. Unless your parents have a substantial amount of wealth saved up for retirement, medical bills, end-of-life expenses, and funeral costs, odds are those expenses and associated debts will be passed on to you. Plus, any outstanding debt your parents might have, like a mortgage or business debt, could also become your responsibility. 

You can’t take out an insurance policy on someone without them knowing (the exception being children under the age of 18), so you have to have a parent’s consent to insure them. Discuss how your finances will be impacted by caring for them in retirement and after they pass away:

  • How much debt will you be taking on? 
  • How will this affect your own retirement? 
  • What kind of healthcare coverage do your parents have? 
  • What are their funeral wishes and associated costs? 

Defining a clear financial picture will help you decide next steps and make your case for their approval and consent.

Why Should I Buy Life Insurance for My Parents?

The main purpose of insuring a parent is to help replace your own lost income and savings, protecting yourself from future debt. 

According to MassMutual:

  • 18% of Americans with household incomes of $75,000 or more know that their parents are counting on them to be caregivers
  • 47% of adults with children of their own spend time caring for parents or in-laws on a daily basis
  • Only 1 in 4 people are prepared for a financial emergency 

The expenses associated with caring for a loved one can wipe out the caregiver financially and be detrimental to the caregiver’s children, who might be relying on them to fund college or other future costs.

Buying a life insurance policy on a parent can help you recoup lost income and savings by paying out a death benefit, provided you are named as the beneficiary. Both term life insurance and whole life insurance will pay out a death benefit; the difference is that term insurance will only payout if the insured dies within a specified term, and whole life insurance guarantees a payout for life.

Whole life insurance also comes with additional benefits not found in a term policy. A whole life policy earns guaranteed interest and non-guaranteed dividends. It has a cash value component, which functions like a high-interest savings account and can be used to fund expenses. It receives favorable tax advantages from the IRS and asset protections. 

Deciding on a Life Insurance Policy

When it comes to buying life insurance for parents, there are multiple types of policies to choose from. And there are ways to insure yourself if your parents won’t consent to being insured. Regardless of the type of policy you buy, you’ll need to determine how much insurance you need:

  • What assets do your parents currently own?
  • What debt obligations do your parents owe?
  • How much do your parents currently have saved?
  • Will you be reducing your work hours to care for a parent?
  • What long-term care costs aren’t covered by health insurance?

Creating this type of balance sheet with your parents and the help of a Wealth Strategist gives you an estimate of how much insurance you’ll need. The next step is to determine how long of a term you’ll need to insure your parent(s) for.

The Case for Term Life Insurance for Parents

Term life insurance policies are designed to payout a death benefit if the insured passes away within the specified term. Typically, terms run in increments of 5 years and max out at 30 years. When buying life insurance for parents, however, it’s important to note that most insurance companies won’t insure a person over age 80. 

If the insured doesn’t pass away within the specified term, the beneficiary receives no death benefit and the premiums paid into the policy are lost. 

So when is term life insurance a good option for a parent?

Say your parents are paying for one of your major expenses, like your student loans or your mortgage, or they’ve cosigned on a loan with you. If they were to unexpectedly pass away without insurance, you’d be stuck with the balance of that expense. A term policy can mitigate the remaining expenses and is a relatively affordable way to protect yourself from financial loss. 

If the financial need only applies for a short term (like until the loan or expense is paid off), then buying term life insurance for parents makes sense.

The Case for Permanent Life Insurance for Parents

If you assume your parents will live past 80—and hopefully they do—whole life insurance is the best type of insurance. As previously mentioned, whole life insurance policies pay out a death benefit for the life of the insured and come with additional benefits that can be used while the insured is still living.

Cash Value & Policy Loans

Whole life insurance builds up cash value over the life of the policy with a guaranteed rate of return and isn’t subject to market volatility. On top earned interest, policies underwritten by mutual insurance are also eligible to earn dividends. Though not guaranteed, the top-rated mutual insurance companies we work with at Paradigm Life have paid out dividends every year for over 100 years. 

The main way cash value in whole life insurance is utilized is through a policy loan, wherein the policyholder borrows against the cash value tax-free, then pays back the loan with interest on a payment schedule of their own choosing. Regardless of the policy loan amount or the duration of the loan, the cash value keeps growing at the same rate because it continues to earn interest and potential dividends on the full cash value of the policy.

When caring for a parent, policy loans are great ways to cover medical bills and replace lost income without depleting your savings. The money you’ve paid in premiums continues to grow inside the policy. Any unpaid policy loans are deducted from the death benefit, effectively lowering your payout when a parent passes away.

Policy loans can also be used to help supplement retirement income. If your parents don’t have sufficient funds for retirement or experience a market downturn that negatively impacts their qualified retirement plan, like a 401(k), the cash value of a whole life insurance policy acts as a volatility buffer to help them maintain their quality of life. In this instance, policy loans wouldn’t be paid back, but reduced from the death benefit with interest.

Asset Protection

Life insurance policies are protected against probate, lawsuits, bankruptcy, and other litigation in most states. This means assets are better protected and the transition of assets inside an insurance policy will be much smoother and faster when a parent passes away, compared to assets held outside the policy. This peace of mind can be priceless when dealing with funeral costs, moving or arranging care for the surviving parent, and managing the remaining estate, not to mention it allows you space to grieve without worrying about financial concerns.

Tax Benefits

Permanent life insurance comes with major tax benefits not found in term insurance. These include:

  • Tax-free policy loans
  • Tax-free growth of cash value
  • Tax-free death benefit to a beneficiary
  • Tax-free retirement income
  • Estate tax exemptions
  • Earns interest and dividends tax-free

While most of these benefits apply regardless of how the policy is structured, some—like the tax-free death benefit to a beneficiary—are dependent upon how the policy is structured. 

How to Structure an Insurance Policy for a Parent

When you buy life insurance for a parent, there are three parties involved:

  1. The insured (your parent)
  2. The policyholder (can be you, can be your parent)
  3. The beneficiary (can be anyone or a charity)

If the three parties are three different people, you create what is called the Goodman Triangle. In this situation, the death benefit payout to the beneficiary would be considered a gift, and therefore would be subject to a gift tax to be paid by the policyholder. Likewise, the estate may also be subject to gift tax. 

To avoid the Goodman Triangle, two parties in the equation must be the same person/people. The most common scenario is that you, the policyholder, are also the beneficiary. If there are multiple beneficiaries listed on the policy, then they should all also be listed as policyholders. Another option is to register an irrevocable life insurance trust as the owner of the policy.

Alternatively, your insured parent can be the policyholder. This doesn’t necessarily mean they have to pay the policy premiums—you could pay them, split them with your parents, or split them with your siblings. 

Because policy premiums are determined by the age and health of the insured, don’t wait to buy life insurance for your parents. Another benefit of buying early is that a whole life insurance policy structured for maximum cash value will have more time to grow wealth. 

Irrevocable Life Insurance Trusts

Insuring one or both of your parents is a proven way to protect yourself financially, but in most cases you also already own life insurance policies on yourself and your spouse—perhaps you’re even considering policies for your children. If growing and protecting wealth for generations to come is a priority for your family, an irrevocable life insurance trust is an ideal place to house all your family’s insurance policies and protect assets.

Irrevocable life insurance trusts (ILITs) offer these key benefits:

  • Minimize or eliminate estate taxes
  • Help avoid gift taxes
  • Avoid probate
  • Increase asset protection
  • Create a path to generational wealth
  • Increase control over policy proceeds
  • Don’t interfere with government benefit eligibility

If you already own insurance policies, you can transfer them into an irrevocable life insurance trust, but if you pass away within 3 years of the transfer, those policies will be subject to estate taxes. If you haven’t yet purchased life insurance, you can set up a trust and purchase policies through it, in which case the 3-year look-back period does not apply.

It’s typical to list the trust as the beneficiary for the insurance policies, but list your family as beneficiaries of the trust. This way, death benefits from any insurance policies owned go back into the trust, where they can be used to purchase additional assets and insurance policies. This is one of the best ways to create a lasting legacy with generational wealth and set up your own personal family bank. 

If you’re ready to explore insurance options for your parents, speak with a Wealth Strategist today. We work with the nation’s top-rated mutual insurance companies to create a policy that meets your financial needs while taking into account your parents’ wishes for leaving a lasting legacy for their heirs. 

At Paradigm Life we can customize a policy to fit your financial situation. Our expert Wealth Strategists are available to answer your questions and show you customized illustrations, outlining an individual plan of action to help you achieve your goals. Request a free virtual consultation, no strings attached.