Most people need to own life insurance at different times
for survivor income or estate planning purposes. Unfortunately life insurance
can be a complicated product, and it’s important to avoid some mistakes that
can result in unnecessary taxation or disputes.
Including
the Death Benefit in Your Taxable Estate
If you are both the owner and insured of a life insurance
policy, the death benefit will be included in your gross taxable estate. With
the federal estate tax exemption at $5,450,000 in 2016, federal taxation is
probably not an issue for most people. However, many states have a separate
inheritance or estate tax with a much lower threshold. For example, New Jersey
has an exemption of only $675,000, and Massachusetts begins taxing estates at
$1 million. To get the death benefit out of your estate and avoid this problem,
consider having your spouse, significant other, or an irrevocable trust own the
policy and also be the beneficiary.
The Wrong
Beneficiaries
One feature of life insurance is the ability to name
beneficiaries and dictate how the death benefit will be distributed. However,
if your spouse or partner predeceases you and no contingent beneficiaries have
been named, the death benefit may revert back to your estate. This means the
proceeds could be distributed according to the instructions in your will, or if
there is no will according to state intestacy rules. So it is important to name
contingent beneficiaries. Additionally, after the death of a spouse or a
divorce, don’t forget to update your beneficiary elections, including for group
policies.
Policy Loans
and Lapses
Insurance companies promote taking loans against the cash
value in permanent life insurance policies. But many policyholders don’t
realize they need to pay back the loan. They just continue making the scheduled
policy premium payments (or stop paying the premium all together) thinking the
remaining cash value will carry the policy. If the loan is not paid back,
interest starts to accrue and eventually the policy can lapse. The premium
payment and/or remaining cash value may not be enough to cover both the
interest on the loan and the cost of insurance that is withdrawn each month. If
you own a policy that lapses and the amount of the loan and accrued interest
exceed your cost basis, any gain will be reported as taxable income to the IRS.
The cost basis of a policy is the cumulative amount of gross premium that you
have paid over the years, less any withdrawals.
Buying Based
on Price
Buying a term life insurance policy based just on price may
be a mistake. It’s usually worth shopping around and sometimes paying a
slightly higher premium for a policy that allows you to reduce the face amount
of coverage, if desired, as well as to convert all or a part to a permanent
policy through at least age 65. Check the fine print; some policies limit reductions
in coverage as well as what kind of permanent policy is available for
conversion.
Surrendering
a Policy
If you own a permanent policy and no longer need the
coverage, don’t just surrender the policy. You could have a taxable gain if the
accumulated cash value exceeds your cost basis. And don’t just transfer the
entire cash value to an annuity under Section 1035 of the tax code. An annuity
has less favorable tax treatment and requires taxable earnings to be
distributed first, followed by the tax-free return of basis.
Instead, first
withdraw (not loan) your cost basis from the life insurance policy, and then
1035 exchange the remaining cash value (earnings) to a tax-deferred annuity.
The cash value can continue to grow, and you can take distributions as desired,
subject to the contract surrender schedule. All of the distributions would be
taxable.
Taxable
Transfer
Under IRC Section 2035, the death benefit of a life
insurance policy can still be included in the owner’s estate for three years if
the policy is gifted to an Irrevocable Life Insurance Trust (ILIT). The
three-year rule applies to any free transfer. However, the rule does not apply
to the sale of a life insurance policy to an ILIT for full and adequate value.
The ILIT should be drafted as a grantor trust, which allows the sale to skirt
both the three-year rule and any transfer for value issues.