Avoid these life insurance mistakes
- By Milt x_Zall
- Aug 18, 2000
Life insurance is fairly straightforward, but the larger your estate is,
the more likely you'll use life insurance for estate tax and business purposes.
That's when things get complicated. Here are some common mistakes to avoid.
Mistake 1: Assume that life insurance proceeds are free of tax.
Yes, the beneficiary receives the proceeds free of income tax. But those
same benefits may be subject to estate tax. Assume you have a $1 million
estate, including your current life insurance. The first $675,000 is exempt
from estate taxes unless you've reduced that exempted amount by making taxable
lifetime gifts. The federal tax on the remaining $325,000 of your estate
is $125,250. Assume you buy a life insurance policy for exactly that amount
to cover the taxes. However, don't forget that the value of that life insurance
policy ($125,250) will now be included in your estate, and your estate will
pay taxes on it — to the tune of an additional $51,353.
Mistake 2: Fail to change ownership properly.
One way to exclude life insurance proceeds from your estate and avoid
the estate taxes is to change who owns the policy. For example, you might
name your adult child as the owner and beneficiary of the policy, with you
as the insured. Another common technique is to transfer ownership of a policy
to an irrevocable life insurance trust. But be wary of tax traps. If you
simply transfer ownership of the policy to the trust or your child, and
you die within three years of the transfer, the proceeds are included in
your estate. You can avoid that by having the child or trust buy the policy
on your life. However, if you're not in good health and the insurance company
won't sell you a policy, you're out of luck. No matter which way you transfer
ownership, you may have to deal with gift tax issues if you give money to
the trust or your child to pay the premiums and they're more than $10,000
The main thing is to remember to change the ownership and the beneficiary.
In a recent court case, an insured person had transferred ownership of a
$1 million policy to a life insurance trust but failed to make the trust
the beneficiary (he also died within three years of the transfer). The mistake
cost the insured's heirs $450,000 in estate taxes that might have gone to
them if things had been handled properly.
Mistake 3: Misunderstand beneficiary implications.
Simply having someone else own the policy can still cause problems.
A common mistake is to name one spouse as the owner of the policy on the
life of the other spouse, and then name the child (or life insurance trust)
as beneficiary. When the insured person dies and the proceeds pass to the
child or trust, the surviving spouse is deemed to have made a gift of the
full value of the proceeds, minus the $10,000 annual gift-tax exclusion
if no other gifts were made in that year. That's a steep gift tax on a $500,000
or $1 million policy. Have the child or trust be both owner and beneficiary.
Mistake 4: Instruct the life insurance trust.
An irrevocable life insurance trust document that requires the trustee
to use the life insurance proceeds to pay the estate taxes of the insured
could bring the proceeds back into the estate and subject them to federal
estate taxes. Don't issue such instructions (at least not in writing).
Mistake 5: Make improper exchanges.
Increasingly popular are second-to-die policies. These policies pay
upon the death of the surviving spouse, and their premiums are substantially
less than separate policies for the same total amount. However, exchanges
of a couple's separate life policies for a joint second-to-die policy don't
qualify for tax-free exchanges, and any gains that have accrued in the original
policies become taxable income.
Many thanks to Dennis Filangeri, a certified financial planner based
in Metairie, La., and the Financial Planning Association for providing information
for this article.
Zall, Bureaucratus columnist and a retired federal employee, is a freelance
writer based in Silver Spring, Md. He specializes in taxes, investing, business
and government workplace issues. He is a certified internal auditor and
a registered investment adviser. He can be reached at email@example.com.