A life insurance policy offers benefits no other financial vehicle can offer because of its tax favored status, its flexibility, and the leverage and liquidity it provides families. At the same time, life insurance can be complex and clients and their other financial advisors would be wise to seek the help of a life insurance specialist to navigate the complexity and deliver simplicity to the process of purchasing a policy, or exchanging or transferring an existing one. Here are 10 things not to do with a life insurance policy:
1. Don’t skip a policy review.
Having an annual policy review will provide the opportunity to assess the policy’s performance and whether or not the policy continues to meet needs through different life stages.
2. Don’t do it alone.
Life insurance policies can be very complex and the ownership structure and tax implications must be considered. A life insurance specialist can help clients and their other financial advisors keep things simple while minimizing tax traps.
3. Don’t take distributions from a policy that is classified as a MEC.
Permanent life insurance that accumulates cash values can provide attractive tax benefits in the form of tax deferred growth and tax-free access to the cash values. Generally, the rule is that cash values can be withdrawn down to basis in the policy, after which policy loans can be taken to avoid taxation. However, there is an exception. If a life insurance policy is classified as a Modified Endowment Contract (MEC), meaning that the amount of premiums permitted in the policy exceed the maximum allowed under IRC Section 7702A, which defines life insurance. Distributions (meaning loans, withdrawals, surrenders, or pledges or assignments of the policy as collateral) taken from a MEC are subject to income taxes to the extent of gain in the policy. Unlike a non-MEC policy, gain is recognized first. A 10% penalty for loans or withdrawals taken prior to age 59 1/2 may also apply to policies classified as MECs. However, the death benefit proceeds of a MEC continue to be income tax free, just like a non-MEC policy.
4. Don’t take withdrawals from certain policies in the first 15 years.
Some policies have very large premiums compared to the amount of death benefit coverage. Because of the tax favored status of the accumulation and distribution of cash values in a permanent life insurance policy, IRC Section 7702 has a recapture provision that taxes distributions based on the changes in cash values relative to death benefit coverage within the first 15 years of a policy. The best way to avoid this is to not take distributions from policies subject to the recapture prior to year 16.
5. Don’t fail to follow the Notice and Consent rules.
When an employer owns a life insurance policy on the life of an employee, she must follow certain rules under IRC Section 101(j) to provide notice and consent to covered employees. Otherwise, the death benefit proceeds will not be taxable. These requirements must be met prior to the policy being issued. The employer must provide the insured-employee with notice that the employer is obtaining life insurance on the employee’s life, as well as the amount of coverage purchased, and obtain consent from the employee agreeing to the coverage. If the consent is not secured, the only way to rectify this in the future is to reapply for the coverage and receive notice and consent prior to issuance of the policy.
6. Don’t triangulate a policy.
Generally, life insurance proceeds are income tax free when received as specified under IRC Section 101 (a)(1), with a few exceptions. However, when three different parties are designated as owner, insured and beneficiary, the proceeds will be income taxable. That is, the owner of the policy will be deemed to have made a taxable gift of the entire proceeds to the beneficiary because the owner is not the insured. The solution is to ensure that either the insured and owner or the owner and the beneficiary are the same. When life insurance is purchased for business needs triangulation can occur when the business is designated as the owner while a spouse or children are beneficiaries and the business owner is the insured.
7. Don’t name the estate as beneficiary.
When the estate is named as beneficiary, the policy proceeds are unnecessarily subject to the probate process, the claims of creditors and estate or state inheritance taxes. Subjecting the policy to probate means that there can be a significant delay in the receipt of the proceeds, as well as a lack of privacy. Whenever possible, it is best to name an individual(s) or a properly structured trust as beneficiary.
8. Don’t trigger the Transfer for Value rule.
As specified under IRC Section 101(a)(2), a portion of the death benefit becomes subject to income taxes when the life insurance contract or death benefit has been transferred for cash or valuable consideration. The excess of the death benefit over the amount actually paid for the policy, in addition to premiums and any other amounts paid by the transferee following the transfer, is the portion that is taxable. This can happen when policies are transferred to and from business owners in a business succession plan. However, there are exceptions to the rule. If the transfer is made to any of the following, the death benefit is received income tax free: The insured individual, a partner of the insured, a partnership in which the insured is a partner, a corporation in which the insured is a shareholder or an officer. Another exception is made for a transferee who takes the transferor’s basis in the policy.
9. Don’t make a gift of a policy that is subject to a loan.
When a gift of a policy is made to another person or a trust, a portion of the death benefit will be subject to income taxes if the policy carried with it a loan in an amount that exceeded the basis of the policy. Basis is generally defined as total premium outlay. The key is to ensure that the loan amount does not exceed policy basis at the time of the gift.
10. Don’t use policy values to repay a policy loan before exchanging the policy.
Older policies can be exchanged for newer, lower cost policies that may include contemporary features that accelerate the death benefit during lifetime to cover long-term care expenses. The exchange is deemed tax-free under the IRC Section 1035 as long as the rules are followed. When it is determined that a 1035 exchange makes sense, if there is an existing loan on the old policy, it will be necessary to ‘carry it over’ in the exchange to the newer policy instead of using cash values to repay it prior to the exchange. That is, if cash values are used to repay the loan immediately prior to the 1035 exchange and there is gain on the policy, the policyholder will be income taxed on the gain immediately, up to the amount of the loan. To avoid this scenario, be sure to either use funds outside of the policy to repay the note prior to the exchange, or to carry the loan over to the new policy. In the latter case, the loan on the new policy can then be repaid using the new policy’s cash values no earlier than 2-3 years after the exchange has taken place. Beware that the new policy may have surrender charges that apply if the cash values of the new policy are used to repay the loan.
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