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. (See also: Estate taxes. Who Pays What? And how much?)

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and/or remaining cash value may not be enough to cover both the interest on the loan and the cost of insurance that is withdrawn each month.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. (See also: Whole or Term Life Insurance: Which Is Better?)

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. (See also: When is it a good idea to use an irrevocable life insurance trust?)

The Bottom Line

Life insurance is a versatile product that can be tailored to meet many needs. There are three parties to a life insurance policy: the owner, insured, and beneficiary, and it’s the policy owner’s responsibility to understand the consequences of how the policy is structured and funded.

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