Common Life Insurance Traps and How to Avoid Them

Beware these common traps made with life insurance that can reduce its value to your family ... or leave you paying a bundle to the IRS.

Trap: Owning too much life insurance, too long. During the years you are working and raising a family, you probably need a substantial amount of life insurance to protect your family against the possible loss of your income.

But as your senior years approach - with your children grown, the mortgage paid off and retirement accounts funded - your insurance needs may be sharply reduced.

For many, the justification for owning life insurance is to finance estate taxes. But this need has been reduced by recent tax law changes that increase the estate and gift tax exemption amount for individuals to $1 million.

By paying for unneeded insurance protection, you pass up the opportunity to acquire higher yield investments.

STRATEGY

Review your insurance needs in light of changes in your personal circumstances and in your estate tax exposure. If you find that you own too much insurance, consider..

*Swapping your life insurance for a tax-deferred annuity issued by an insurance company to obtain an increased investment return. This can be arranged through a tax-free exchange, which enables you to avoid any taxable gain on the disposition of the insurance policy.

*Donating your insurance policy to charity. You'll get a tax deduction for the cost basis in the policy-generally, the amount of premiums you've paid into it.

*Making a gift of the policy to your child or grandchild. The policy benefit will be tax free to the recipient, giving the child a valuable head start on financial security. The gift also will remove the policy from your taxable estate, assuming you survive three years after the gift.

You can avoid paying gift tax on the transfer by utilizing your annual gift tax exclusion (currently $10,000 per recipient, or $20,000 when gifts are made by a married couple) and, if necessary, using part of your estate and gift tax exempt amount.

*Cashing in the policy. This will put cash in your pocket, but you will realize taxable income to the extent that the amount received for the policy exceeds what you paid into it through premiums.

Estate tax planning: If you find you still need some life insurance to finance potential estate taxes, consider using a second-to-die policy that covers both you and your spouse and pays its benefit on the death of the survivor.

The estate tax marital deduction lets all of one spouse's assets pass estate tax free to the surviving spouse, so it is on the death of the surviving spouse that a couple's estate tax liability becomes due.

A second-to-die policy can provide funds to finance such an estate tax bill at substantially less cost than that of buying two insurance policies to cover each spouse separately.

TRAPS

*Owning insurance on your own life. This can cause insurance proceeds to be subject to estate tax at rates of up to 55%, because when you die owning a policy on your own life the proceeds are included in your taxable estate.

Avoid this trap by having the policy beneficiary own it, or by creating a life insurance trust to hold the policy and distribute the proceeds according to your instructions.

You can still finance the premiums on the policy by making gifts to the policy owner (beneficiary or trust), using your annual gift tax exclusion to shelter the gifts from tax.

Benefit: When insurance on your life is owned by the beneficiary, the insurance proceeds will be estate and income tax free.

Related mistakes to avoid...

*Owning insurance on your own life and naming your spouse as your beneficiary. The insurance proceeds will escape estate tax on your death due to the unlimited marital deduction - but if your spouse dies owning the proceeds, they will be taxable in his/her estate.

*Owning insurance on one person's life and naming a third person as beneficiary.

Example: One spouse owns insurance on the other spouse's life, and names a child as beneficiary.

The trap here is that because the policy owner controls the designation of the beneficiary, the payment of the benefit to the beneficiary is deemed to be a taxable gift made by the policy owner.

Again, avoid this trap by having the beneficiary own the life insurance policy, or by having a life insurance trust own the policy.

Important: If you set up a life insurance trust to own insurance, be sure the trust is drafted by a specialist in the area. Trust documents drafted by nonspecialists can easily contain mistaken bad language that fails to comply with technical requirements, thus causing the trust to fail.

*Borrowmg against life insurance. It can be tempting to borrow against life insurance, because policy loans can provide a tax-free source of cash and carry a low interest rate.

But a couple of traps may result from borrowing against insurance...

*When you borrow against insurance you reduce the insurance benefit for which you presumably bought the insurance, leaving your family more exposed to financial risk.

Dangerous scenario: Typically, interest on a loan against insurance is not paid in cash but is charged against the policy. If the loan is not repaid and the interest compounds, the loan can grow until it equals the policy's value. Then the policy will terminate, and you will realize taxable income in the amount of the unpaid loan (a "forgiven debt") minus your basis in the policy even though you receive no cash income with which to pay the tax.

*If you borrow against insurance and then transfer the policy to another person, the policy benefit may become subject to income tax.

Wby: When a policy that has been borrowed against is transferred by gift, the recipient is deemed to have purchased the policy by assuming the outstanding loan obligation, with the amount of the assumed loan being the purchase price.

And, under the Tax Code, when an existing life insurance policy is purchased the policy benefit becomes taxable income to the purchaser if the purchase price exceeds the donor's basis in the policy.

Example: A parent owns a $500,000 insurance policy on his/her own life that has a $100,000 cash value. He has a cost basis of $60,000 in the policy. He borrows $90,000 from the policy to reduce its cash value to $10,000, then makes a gift of the policy to a child.

The result is that the child is deemed to have purchased the policy by assuming the $90,000 loan obligation. Therefore $410,000 of the policy benefit will be taxable income to the child when paid out, instead of being tax free.

Bottom line: Loans cause problems, so it's best not to take out loans against life insurance.

If you've already taken out loans against life insurance, review them with an expert for any unexpected problems they may cause.