Six Common Mistakes People Make With Life Insurance
Life insurance can be a very valuable tool for building, protecting and transferring wealth. In addition to protecting families and businesses from loss, life insurance can provide powerful income tax and estate tax benefits, especially for high-net-worth individuals.
Life insurance, however, is also a very complex tool. It is easy to make mistakes in purchasing and managing your policy, and these mistakes can be very costly. Some mistakes might result in you paying a significantly higher premium than necessary. Others might cause your policy proceeds to be inadvertently subject to estate, gift, or income tax.
Here are six of the most common mistakes people make regarding their life insurance policies:
- Failing to manage medical underwriting process. Despite all of the math involved, underwriting is not an exact science. The ratings and premiums that a person qualifies for can vary significantly from one carrier to the next. That is why it is so important to obtain underwriting offers from many different carriers. Your life insurance broker should utilize a preliminary informal application to collect your detailed medical history and provide that to at least eight different high-quality carriers. This essentially creates a competitive auction for your business.
If one carrier provides a quote that is superior to the others, your broker can use that offer as leverage to request improvements from the other carriers. Once all of the carriers have come back with their best offers, the broker can work with you to evaluate the offers based on product type, premiums, customer service, and other important factors. By forcing the carriers to compete directly with each other, we often see carriers reduce their premiums by upwards of 40% from their first offer.
- Ignoring current market trends. Many people are paying significantly higher premiums than necessary because they take a “set it and forget it” approach to life insurance. They think that once they buy a policy they are stuck with that policy and its premiums for the rest of their lives.
In reality, many people could significantly lower their premiums by comparing their existing policies to today’s market offerings. The life insurance market is fluid; mortality costs, company expenses, product features, interest crediting rates, and certainly medical underwriting standards are just a few of the variables that the industry and individual carriers review and change regularly. Additionally, medical conditions that you had when you first purchased your policy may be viewed more liberally today. Your life insurance broker should serve as your advocate in thoroughly examining your in-force policies against current offerings to see if you can secure better coverage at lower premiums.
- Naming the wrong policy owner or beneficiary. One of the primary reasons many families purchase life insurance is so that the proceeds of the policy will be excluded from the older generation’s taxable estate. This can be accomplished by using an irrevocable trust or naming the younger generation as owners in a way that avoids incidents of ownership.
Often, however, people fail to make certain that they have taken appropriate steps in establishing the policy, and they do not check with the carrier to ensure proper compliance with the intended estate planning goals. It is not uncommon for the carrier to have improper designations recorded, which makes it very difficult to correct at the time of a claim. With the federal estate tax reaching 40%, in addition to state estate taxes, these can be extremely expensive mistakes.
- Violating transfer-for-value rules. One of the biggest benefits of life insurance is that the proceeds generally are not subject to income tax. This income tax break, however, can be nullified if the “transfer-for-value” rules have been violated. A transfer-for-value occurs when interest in a life insurance policy is transferred to another party in exchange for “valuable consideration.” Consideration is broadly defined; money does not even need to change hands to trigger the rule. For example, simply naming someone as a beneficiary as part of a mutual promise can be deemed a transfer-for-value.
The IRS allows transfers to occur without violating the transfer-for-value rules when it involves transferring a policy to the insured, a partner of the insured, a partnership in which the insured is a partner, or a corporation in which the insured is an officer or shareholder. Under these exceptions, transfers can take place without the proceeds being subject to income tax.
- Improperly initiating a 1035 exchange involving outstanding loans. Under the 1035 exchange rule, an existing policy can be exchanged for a new one without generating taxable gains. But if the policyholder receives cash or some other form of additional payment (referred to as “boot”) through the exchange, any gains are taxable to the extent of the boot.
An outstanding policy loan will likely be recognized as boot. Therefore, if you are exchanging a policy that has an outstanding loan, it is prudent to either pay off the loan before making the exchange or carry the loan over to the new policy. If you carry the loan over, you should allow a reasonable period of time—certainly more than one year—before surrendering cash in the new policy to eliminate the loan.
- Inadvertently turning life insurance into a Modified Endowment Contract (MEC). To qualify for tax-free distributions, tax-deferral of accumulated buildup with FIFO tax treatment, and other favorable tax treatment, policies must meet the definition of life insurance under IRC Section 7702. Policies that fail to meet these criteria are classified as MECs. In addition to losing the favorable tax treatment, MECs also incur a 10% penalty unless the policy owner is disabled or older than 59 ½.
When purchasing a policy, it is important to make sure the policy meets the strict criteria for life insurance. Also, if you have an in-force policy that has already been classified as life insurance, you need to take care not to modify the policy in a way that reclassifies the policy as an MEC. Such modifications include increasing or decreasing the death benefit, converting a term policy to a permanent life policy, and executing an exchange that does not qualify as a 1035 exchange.
Purchasing and managing life insurance policies can be a very complicated process with many potential pitfalls along the way. For people in high income tax brackets and with estates greater than the $5.34 million exemption amount, these seemingly tiny mistakes can be very costly.
At Goldstein Financial Group and the Insurance Design Center, we are dedicated to being an advocate for individuals throughout the life insurance process and helping them to avoid these mistakes and maximize the value of their assets. If you have any questions about the topics discussed above or your specific insurance needs, we are here to help. Contact us