Life Insurance Planning - Mistakes to Avoid

This guest post was written by MacCorkle Insurance Services in Burlingame.

A life insurance policy is one of the most important purchases you will ever make – but it is not always an easy one. Life insurance is not a one-size-fits-all commodity; there are rules that surround the purchase of life insurance products which are not always easy to interpret, leaving room to make serious and ultimately costly mistakes.  A professional insurance advisor can help identify and guide you past these pitfalls.  Here are some common mistakes that people make when purchasing a life insurance policy.

Mistake #1:  “The Unholy Trinity” – Three People on a Policy

The beneficiary of a properly structured life insurance policy will generally receive the proceeds of the policy both income and gift tax-free.  An ‘unholy’ trinity exists when three different parties are designated as 1) the owner, 2) the insured and 3) the beneficiary of a life insurance policy. If an insured dies under these circumstances, the proceeds are considered to be a gift from the owner of the policy to the beneficiary.

Example:  Jane owns a policy on her husband John and the beneficiaries of the policy are their children.  Upon John’s death, the policy proceeds are considered to be a gift from Jane to her children and thus subject to gift taxes.  Since Jane has not received any benefits from the policy proceeds, she will have to pay gift tax out of her personal assets.

The solution: The insured and the owner should be the same individual OR the owner and the beneficiary should be identical.

Mistake #2:  The Business ”Unholy Trinity”

This is similar to the first mistake.  In this situation though, the business is the owner of the policy.  This form of the ‘unholy trinity’ occurs when business owners name themselves as the insured, use the business to own the policy and then name a spouse, children or another business owner as the policy’s beneficiary.  The difference is the tax consequences change.  In this situation, the proceeds that are paid to the beneficiaries are subject to income tax rather than gift tax.

The solution:  Again, proper structure of the policy ownership and beneficiary designations; the business needs to be both owner and beneficiary OR the owner and the insured need to be identical.

Mistake #2:  Estate as Beneficiary

When the estate is named the beneficiary of the policy (or becomes the beneficiary of the policy unintentionally when the beneficiary predeceases the insured and no successor beneficiary is named), the policy proceeds may needlessly be subject to probate, claims by creditors and potentially estate or inheritance taxes.

The solution: Be sure to name both primary and contingent beneficiaries to the policy.

Mistake #3:  Policy Subject to Estate Tax

If an individual is the owner of his or her policy, all of the death proceeds are included in his/her estate.  For most individuals, this is not a problem.  However, for an individual that has a large estate, this could trigger unnecessary estate taxation.  A frequently proposed solution is to transfer the policy ownership to a trust or a third party – easy, right?

The problem that arises is this:  the Internal Revenue Code contains a rule that stipulates when an insured gives away a personally owned policy on his/her life, to another person, a trust or entity and then dies within three years of the transfer, the policy proceeds would be subject to estate tax.  With the estate tax exemption now indexed for inflation, this could be particularly dangerous if the insured is on the brink of having to owe estate taxes and has not planned for the possibility of having to owe taxes and the estate is primarily comprised of a small business or real estate – assets not easily liquidated.  The inclusion of the policy in the insured’s estate could push it over the threshold, leaving a potentially nasty unintended surprise for the heirs.

The solution:  there exist a number of complex ways to structure a transfer to avoid the three-year estate inclusion, but one simple solution is to purchase a term policy to cover the three year period during which the other policy would be subject to estate tax.

Mistake #4:  Failure to do Policy Reviews

Circumstances change.  A life insurance policy should be reviewed every three years or whenever there has been a change in your life that would warrant an immediate review.  Changes would include things such as marriage, divorce, birth of children, a promotion, a new job, the purchase of a new home.  It is also a good idea to review exactly how the policy works – who is the beneficiary, what are the guarantees and benefits or the effects of interest rate changes or late premiums.  The consequences of failing to do a periodic review can be devastating.

A real life example occurred recently when the Supreme Court handed down a decision in the case of Hillman v. Maretta.  A federal employee designated his ex-wife as the beneficiary of his group life insurance policy, offered to federal employees through the Federal Employee’s Group Life Insurance Act of 1954 (FEGLIA).  He and his wife eventually divorced and later on he remarried - but he failed to update his policy’s beneficiary designation.  When the insured passed away, the policy benefits went to his ex-wife but that was not his intent.  The state law indicated that when a married couple is divorced, the divorced spouses are no longer automatically the beneficiaries of each other’s life insurance policies.  However, the court voted unanimously that FEGLIA pre-empted state law and as a result, the ex-wife will receive and keep the proceeds.  All of this could have been avoided with a simple signature on a change form.  Be sure to periodically review your life insurance!

MacCorkle Insurance Services is a forward-thinking, highly experienced and full-service insurance brokerage firm.