LIFE INSURANCE MISTAKES
While there are a number of complex ways to structure a transfer to avoid the three year estate inclusion, one simple solution is to purchase term insurance for the three year period during which the policy would be subject to estate tax.
LIFE insurance is one of the most important purchases that you will ever make. The problem is that there is always the potential of making serious and costly mistakes. but, with some education and awareness, you need not repeat them. Lack of education, whether it is on the part of your advisor or yourself, has led to many mistakes, including each of the other mistakes that follow.
Life insurance is not a onesize-fits-all product. Firstly, you need to be comfortable with the insurance company establishment, the insurance agent, and the products being considered before you buy anything. Do not rush when buying any insurance product. Spend a lot of time to research on the insurance company of your choice and the products they offer, before you purchase any thing and you can save yourself a lot of headaches later.
There are instances when some clients may have endorsed three people on one policy. So called the “Unholy Trinity.” The beneficiary of a properly structured life insurance policy will generally receive the death proceeds, income tax free. However, where the so-called “unholy trinity” exists, policy proceeds are subject to taxation.
The “unholy trinity” exists when three different parties are designated as the owner, the insured, and the beneficiary of a life insurance policy. Should the insured person die under those circumstances, the policy proceeds are considered to be a gift from the owner to the beneficiary. The solution is very simple, either the insured and owner should be the same individual or the owner and beneficiary should be identical.
The Business “Unholy Trinity” mistake is similar to the prior mistake; however, in this situation, a business is the owner. This form of “unholy trinity” frequently occurs with business owners when they name themselves as the insured, use the business to own the policy, and name a spouse, children, or another business owner as the policy beneficiary.
The negative tax consequences of the transaction are changed if the business owns the policy. In this situation, the death proceeds paid to the beneficiaries are subject to income tax instead of gift tax. Like the previous mistake, the solution lies in properly structuring the policy ownership and beneficiary designation.
Failure to name a successor owner. This is because when we think of the assets that we own, we generally think of stocks, bonds, and real estate. All too often, we fail to think of an insurance policy as an asset.
If the owner and insured on a life insurance policy are two different people and the owner dies first, the policy ownership has to pass to a successor owner. If the policy owner did not name a successor owner, the policy will be subject to probate (The court process by which a Will is proved valid or invalid.) Probate can cause the policy to be subject to creditors’ claims and unnecessary costs. It can also cause ownership of the policy to pass to an unintended owner or to be divided among multiple owners.
The solution is quite simple, where the insured and owner are different individuals, ei- ther name at least one successor owner or have an entity such as a trust to own the policy. An Estate as beneficiary mistake occurs when the estate is named or becomes the beneficiary of an insurance policy. The estate may become the beneficiary unintentionally. For instance, if only one beneficiary is named but he or she predeceases (dies before) the insured, then, by default, the estate becomes the beneficiary.
If the insured’s estate is the beneficiary, the policy proceeds may needlessly be subject to probate, creditor claims, and estate or inheritance taxes. The solution is to name both primary and secondary beneficiaries.
If an individual is the owner of his/her policy, all of the death proceeds are included in his/her estate. For most individuals, this will not be a problem, however, if the individual has a large estate this may trigger unnecessary estate taxation. Typically, when an individual discovers that ownership of a policy creates an estate tax problem, he or she transfers ownership to another individual or to a trust.
That sounds like a quick and easy solution, but it could be a mistake. There is a rule that provides that, if an insured owns a policy on his or her life and gives the policy to another person, trust, or entity and then dies within three years of the transfer, the policy proceeds will be included in the estate of the insured and subject to estate taxation.
While there are a number of complex ways to structure a transfer to avoid the three year estate inclusion, one simple solution is to purchase term insurance for the three year period during which the policy would be subject to estate tax.
Failure to meet notice and consent requirements on an employer-owned contract. It is not unusual for a business to purchase insurance on the life of a key employee or owner. At first glance, you might wonder why any business would purchase life insurance. Fortunately, where specific employee notice and consent requirements are met and certain exceptions apply, a business can continue to receive death proceeds income tax-free. The notice and consent requirements must be met before policy issue. Failing to meet the notice and consent requirements is mistake.
If the specific notice and consent requirements are not met before policy issue, the only corrective option appears to be reissuing the contract, subject to full underwriting. Consequently, it is important that action be taken prior to policy issue.
The gift of a policy with an outstanding loan is a common occurrence. In fact, individuals often borrow from a policy before transferring it in order to reduce its value for gift tax purposes. But, as with any technique, too much of a good thing can lead to an undesired tax result.
The transfer of a policy subject to a loan, even by gift, is treated as if the policy owner sold the policy and received money equal to the debt deemed forgiven. If the amount of loan exceeds the basis at the time of the transfer, a portion of the death proceeds will be subject to income tax.
On the other hand, if the loan is less than the policy owner’s basis, the death proceeds will generally be received income tax-free by the beneficiaries. Consequently, the solution is to make sure the loan amount does not exceed policy owner basis at the time of transfer.
Exchanging a policy subject to a Loan. Very little in life is static. For a number of reasons, there may be a need to exchange an existing life insurance policy for a new one. One of the requirements is that no money or property other than “like-kind” can be received at the time the policy is exchanged.
And if it is, income will be recognized to the extent of that other property. Like the prior mistake, when an existing policy has a loan against it, if the new policy does not carryover the old loan, the policy owner is treated as if money is received, and any gain in the contract will be recognized up to the amount of the loan. Look out for Part II. Note: In this column I offer insurance information in general. Do not completely rely on this column to make particular insurance decisions. For specific insurance advice email me at; insuculture@gmail.com