The Scottish poet George MacDonald wrote, “Age is not all decay; it is the ripening, the swelling of the fresh life within,” and financial advisors familiar with the intricacies of life insurance know what he means.

As people age, their perspectives on life insurance change significantly. A man in his thirties would buy a policy primarily to ensure that his family could pay their bills in the event of his death.

But someone in his late fifties would have much different concerns, including, “How can I pass on a maximum amount of my estate to my loved ones?” For this older generation, life insurance can play a large role in their wealth handoff.

“Life insurance is a nice vehicle for transitioning wealth because its benefits are tax-free,” says Josh Hazelwood, director of estate and business planning at MassMutual Financial Group, in Springfield, Mass.

A Refresher

As most people know, there are two general types of life insurance policies — term and permanent. On term policies, premiums are paid over a fixed period of time, and when the premiums end, so does the policy. If the policyholder dies while still paying the premiums, his heirs will get the assigned payout (the “death benefit”) income-tax free.

Permanent policies, meanwhile, offer a death benefit with an investment angle. A permanent policy has a cash account that allows the excess money to grow tax-deferred. Premiums are much more expensive because of the tax-deferral bonus.

But there is an important consideration in using life insurance policies as an estate planning tool: while the death benefit is income-tax free, it is not automatically estate-tax free.

For those clients eager to avoid estate taxes as well, advisors can recommend the very popular irrevocable life insurance trust. In this insurance vehicle, the policy is put in the trust, and the trust, in turn, takes ownership of the policy. The trust then pays the policy premiums and distributes the death benefit and the remaining money according to the terms of the trust. Since the trust owns the policy, it is no longer in your client's estate, so there will be no estate tax to be paid at his death. It's important to remember that the trust needs to be funded so that it can pay the premiums. The client can do this in the form of gifts each year. Then he can use his $11,000 annual gift-tax exclusion and make a gift to each of the beneficiaries of the trust.

Be sure your client makes the gift to the trust at least 30 days before the premiums are due. And be clear that the payments are “present interest gifts,” so that those payments qualify for the $11,000 annual exclusion. Otherwise he will owe gift tax on those payments.

A technical note: To make gifts to the trust, they must be drafted with “Crummey” powers, named after a famous court case. All that means is that every year, the trust beneficiaries must be notified of the amount that has been given to the trust. They then have 30 days to withdraw any amount in excess of their share of the gift. Ideally, your client discusses this with his heirs and insists they do not touch the money until after his death. Irrevocable life insurance trusts are not without drawbacks. For starters, the client relinquishes control of the life insurance policy, even though he's still paying premiums each year. In addition, he can't change the terms of the trust once it's established and if he dies three years after the policy has been transferred to the trust, the insurance proceeds will be considered part of his estate.

Hedge Funds

If your client is interested in investing in hedge funds and has the money to do so, life insurance policies offer a great tax-efficient way to do so.

Remember, hedge funds are only offered to accredited investors or qualified purchasers as private placements, says Mike Chong, vice president and associate general counsel of MassMutual. (“Accredited investors” are those with $1 million in net worth and have made $200,000 in the last two years, $300,000 if combined with a spouse. “Qualified purchasers” generally have $5 million in investable assets.)

While hedge funds typically beat the general market's returns, their managers have a reputation of doing a lot of buying and selling. Each time a share is sold at a gain, the investor incurs a tax hit, and though net gains over the long haul are generally very sizable, the annual tax bill can be ugly.

To alleviate these tax hits, stick the hedge fund in a permanent life insurance policy, suggests Bill Fleming, director of personal financial services at PricewaterhouseCoopers in Hartford, Conn. Then the annual earnings will be tax-deferred, and the client won't pay a dime.

The bigger insurance houses, like AIG, MassMutual and New York Life, call this private placement life insurance. In simple terms, the insurance company contracts with the hedge fund to get its clients in through the life insurance umbrella.

Granted, the fees associated with this technique are pretty hefty, but the tax deferral advantage may just make it worth it. No surprise the IRS is onto this and has had some comments in the last few months, says Fleming.

The IRS has insisted that life insurance investors be separate from regular hedge fund investors. So the hedge funds now have to create a clone of themselves.

“So now there's Bill's insurance hedge fund and Bill's hedge fund for the general public,” explains Fleming.

The funds can be identical but they have to be separated, according to the IRS. It's an administrative nightmare that could translate into higher costs. But again, the long-term gains could still make it worth it.

Your Own Private Pension

Many entrepreneurs lack typical corporate benefits, like a 401(k) and pension plan. Life insurance can help some self-employed people care for themselves in retirement.

“This is a fabulous technique with huge potential for disaster,” warns Fleming. Here's why: Your client can pump money into a permanent life insurance policy and maximize the policy's cash value. That money will grow tax deferred. If he's in a variable universal life policy, he can pick very aggressive investments in hopes that the stock market rockets over the next 20 years before he retires.

One of the perks of permanent life insurance policies is that the money is accessible all along in the form of a loan against the death benefit. So when your client retires, he can start borrowing against his death benefit. Those withdrawals are tax-free to him, although he is hit with an interest charge each year because technically it's a loan and he owes the money back.

But here's where the problems can creep in. Each year the policy is charged mortality and administration fees. The fees get bigger as the policyholder gets older. So your client has to make sure there is always enough money in the policy to cover these fees, even after withdrawals. If the policy doesn't have enough cash and has to be shut down, all those years of withdrawals are taxable at that instance.

“This is very high maintenance for a person who's in his seventies or up,” says Fleming.

But if, as his advisor, you are willing to help him carefully monitor what he's taking out in retirement and what the account is earning each year, this can be a viable option for a self-employed person without a pension because your client could live off all that earnings growth and not pay a dime on it.

In addition to his own pension plan, if your client has his own business, make sure he has life insurance to help the ownership transition after he's gone.

While the business pays the premiums over the years, the proceeds from the policy can be used to cover estate taxes, to buy out a partner's share in the company or just to offer the survivors some extra money while they search for a replacement.

Stay Involved…For Life

As you can see, life insurance can be a great estate planning tool — expecially for older clients. But most of these solutions require the advisor to play a pretty active role in managing the insurance policy.

If you're establishing a life insurance trust, work closely with your client's attorneys. If your client decides to create a private pension, then keep a spreadsheet of the policy's earnings and fees.

Though all of these techniques can produce great results, if they are not properly monitored, they can be disastrous. Then, not only will your client lose a ton of money, you will likely lose a client.