Avoid These Top 4 Life Insurance Mistakes

September is Life Insurance Awareness Month.

Written By Jasper Smith

September is Life Insurance Awareness Month. Because life insurance is one of the most important purchases you will make, careful thought needs to go into purchasing a policy. Many people don’t do the necessary work upfront, which could result in severe and costly mistakes.

Here are four life insurance mistakes you should try to avoid:

Mistake #1: NOT DOING YOUR POLICY REVIEW

You should review any personally owned life insurance at least annually or when you have a life-changing event. Here’s a short list of common life-changing events: Getting married, having a child, buying a house, losing a job, getting divorced, leaving 9-5 to become an entrepreneur, or moving.

A review helps you ensure that your coverage is sufficient or, if not, what changes need to be made. Before making any changes to your current coverage, carefully consider the risks and benefits. Consider your current need for coverage, health status and insurability, fees, and charges associated with terminating an existing contract, as well as future liquidity needs.

Mistake #2: YOUR ESTATE IS YOUR BENEFICIARY

If the insured’s estate is the beneficiary, the policy proceeds may needlessly be subject to probate, creditor claims, and estate or inheritance taxes. This isn’t a good thing, and it can easily be avoided.

So, how does this happen? Two ways: (1) if only one beneficiary is named and they predecease you, then, by default, the estate becomes the beneficiary. This is common because many people might name a parent as a beneficiary and forget to update things long after that parent dies. (2) you don’t designate a beneficiary at the time of the application. (Something I never let my clients do!)

Knowing who is listed as a beneficiary on your policy(ies) is important, and many forget to check it. This is why I encourage people to review their policy at least annually. Not having or having the wrong beneficiary listed is an issue we can avoid.

Mistake #3: THREE’S A CROWD

Normally, a life insurance policy beneficiary will receive the death proceeds income and gift tax-free. However, policy proceeds are subject to gift taxation when three different parties are designated as the owner, the insured, and the beneficiary of a life insurance policy. This is called the “Triangle.”

A federal court decision from 1946 addressed this. It stated that where a “Triangle” exists at the insured’s death, the policy owner (not the insured) will be deemed to have made a taxable gift of the entire death proceeds to the beneficiary. Should the insured person die, the policy proceeds are considered to be a gift from the owner to the beneficiary.

To avoid this mistake, here are two options: the insured and owner should be the same individual, or the owner and beneficiary should be identical.

Mistake #4: TAKING PREMATURE POLICY WITHDRAWALS

There are two characteristics of life insurance that allow it to serve as a great retirement income option:

(1) Cash value build-up is not subject to income tax.

(2) Cash values can be withdrawn (to the extent of basis) or borrowed, free of income taxation.

Please note: It is important to understand that withdrawing or borrowing cash values may decrease the policy’s death benefit.

Congress enacted provisions in the Internal Revenue Code to prevent abuses of the tax-favored treatment of life insurance. The rules generally affect policies with large premiums relative to the death benefits that are issued or exchanged after 1984.

According to what they call the “cash-rich rules,” any time a cash distribution from a policy results in a reduction of the death benefit within the policy’s first 15 years, some portion of the distribution may be subject to income tax. There are many ways to avoid the adverse income tax consequences of a “cash-rich” policy.

The easiest solution is to either wait until year 16 before taking a withdrawal or structure the distribution as a loan.

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