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Four Uses for Life Insurance You Never Thought Of

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We all know the drill about death and taxes. For the first, there's life insurance. But it may surprise some to know that a life policy can also be a solution for the latter.

For those who plan ahead, life insurance can not only reduce taxes, but can be used to salve a host of other financial headaches.

Most of us take out our first life policy when we become parents or homeowners: our first term policy is usually an emergency cord that our survivors can pull in case a breadwinner dies unexpectedly. But some of the most interesting uses of life insurance can come when the kids are out and the house is paid off.

"People tend to see life insurance as a cost you have to have," said Jim Haefner, a financial planner in Charlotte, N.C. "But it has multiple functions."

Those functions can include replacing money you have lost to taxes or donated to charity, maximizing your pension or Social Security benefits, even funding college for the kids and grandkids.

With the approach of the "fiscal cliff," these non-traditional uses for life insurance have been gaining in popularity. (Read more: The Tax on 'People Who Aren't Paying Attention')

Some of these alternative applications can look tricky to the layperson, but they still rely on life insurance's basic purpose: replacing a stream of income, or providing heirs with liquidity when they need it most. But instead of replacing a young parent's salary, the policy replaces the value of an asset, like a home, a business or even another pile of cash.

Funding a Bequest

Steve Hartnett, director of education for the American Academy of Estate Planning Attorneys in San Diego, gives the example of a couple whose beach house, worth $1 million, constitutes half of their wealth. Their two sons don't care about the place, but their daughter has made vacations there a centerpiece of her family's life.

"They can't give the beach house to Sally and have an equivalent amount to other kids," said Hartnett. "So they go out and get life insurance policy for the value of the beach house. At death of the surviving spouse, the kids still have the beach house, they have the $1 million in savings, and they have the life insurance payout."

The key to this strategy was using a life insurance policy to effectively turn the beach house into a liquid asset. "Life insurance is a form of investment that provides liquidity to an estate, period," said Dean Aita at Ericson Insurance Services in Connecticut.

Once you start thinking of insurance as a cash stand-in for assets, it's easy to see other ways to apply life policies to problems of liquidity — the lack of which is often the Achilles heel in affluent families' planning. Most people connect liquidity with whole life, which builds up cash value that the insured can borrow against. But even term policies can provide liquidity on death. The head of a family business can insure himself to be able to distribute the worth of the business to his children who don't join the company. Business partners can take insurance policies that will allow one partners' heirs to, in effect, buy themselves out of their half the business.

Wealth Replacement

Life insurance can also be used for what planners call "wealth replacement." In its simplest form, successful investors can pay for a policy that will cover the estate taxes on their holdings. This prevents his or her survivors from having to busy themselves selling investments while they are grieving — or when selling is disadvantageous — in order to satisfy the taxman.

More complex strategies include pairing a life insurance policy with an instrument like a charitable remainder trust, which allows investors to donate an asset to a charitable cause while drawing the income that the asset gives off. With some of that income, the investor buys a life insurance policy to restore to his or her heirs the amount the charity receives, preserving both the tax deduction and the wealth.

Most financial planners recommend putting the life insurance policy in trust, a legal form that allows you to leave instructions as to how the payout is used.

Pension Maximization

Life insurance strategies are not for the wealthy alone. Many who expected to leave their children an inheritance before the 2008 downturn, for instance, are using the resources themselves. If a couple who take a reverse mortgage can dedicate a portion of the monthly payment to a life policy, however, they can preserve the value of the home for their heirs and still have a roof over their heads.

A well-funded whole life policy can also be used to pay college costs if you haven't saved enough in a 529 or other college fund. Though fees and administrative costs make whole life an inefficient way to save for college, a whole-life loan does have the added benefit that federal financial aid programs don't count life insurance money when reckoning how much you can afford to pay.

Similarly, life insurance can cover a financial shortfall in retirement income. A couple recently came to Haefner with a quandary. The husband's pension, which made up a healthy portion of their retirement plan, would stop on his death, leaving his wife with little to live on. The answer Haefner offered was life insurance — not inexpensive at that juncture in the couple's lives, but better than the alternative.

(Read more: Why Aren't Women Saving for Retirement?)

A smarter plan is to decide the details of your pension or Social Security benefit with a life insurance policy in mind. Knowing that your spouse will get an insurance payment on your death frees you up to maximize your benefit — but the earlier you act, the better.

College Costs

There are even some unconventional uses of life insurance that mimic its most conventional purpose: to make sure bills are paid no matter what happens to you. An older couple who want to contribute to their grandchildren's college costs can merely take advantage of the annual tax-free gift of $13,500 to each child. But if they are worried they won't live to complete their program, they can insure themselves for the total amount, and find peace knowing their wishes will be carried out whether they write the last check themselves or leave it to their children.

Life insurance solves so many riddles of financial planning that many insurance brokers, especially the growing number credentialed as financial planners, are thinking of insurance as a way to balance investment risk, not just risk to life and limb. "When you have all your vulnerabilities covered," said Aita, "you can invest in a different way."

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