How to Sidestep Typical Pitfalls with Life Insurance

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If you fall into any of these typical life insurance pitfalls, you might end up costing your loved ones more money or paying the IRS a hefty fine.

Too much life insurance for too long might be a trap. You will likely want a sizeable quantity of life insurance throughout the time that you are earning an income and supporting a family.

However, as you enter your golden years, you may not need as extensive a policy. This is especially true if you no longer have a home to pay off and your retirement savings are adequately established.

Many people get life insurance to cover the cost of their estate’s tax bill. However, new tax laws that double the personal exemption from estate and gift taxes to $1 million have mitigated this problem.

You’re throwing away money that could be invested in higher-yielding assets on pointless insurance coverage.

STRATEGY

As your life and estate evolve, it’s essential to reevaluate your insurance needs. You may have excess insurance if you have one.

Investing more money tax-deferred by exchanging your life insurance policy for an annuity from an insurance company. A tax-free exchange can facilitate this, allowing you to dispose of the insurance policy without incurring any taxable gain.

Giving a charity the proceeds from your insurance coverage. The premiums you’ve paid into the policy are considered the cost basis, which can be deducted from your taxable income.

*Leaving the policy as an inheritance to a kid or grandkid. The policy’s payout will be given to the beneficiary without tax, giving the youngster a head start toward financial stability. If you give away your insurance and live for three years afterward, you won’t have to worry about your estate having to pay taxes on the policy.

No gift tax will be due as long as the transfer is done within the annual gift tax exclusion (currently $10,000 per recipient or $20,000 when a married couple makes contributions).

Taking out a policy payout. The amount by which the proceeds from the sale of the insurance exceed the total premiums paid is considered taxable income and must be reported as such on your tax return.

Planning for estate taxes may involve purchasing a second-to-die policy that ensures both you and your spouse pay its benefit only upon the survivor’s death.

Due to the marital discount for estate taxes, upon the death of the first spouse, the estate tax payment of the couple is deferred until the end of the second spouse.

If an estate tax payment needs to be paid, a second-to-die policy can do it at a much lower cost than two individual policies would.

TRAPS

Having your life insurance is a must. When you die while holding a policy on your own life, the proceeds are considered part of your taxable estate and may be liable to estate tax at rates as high as 55 percent.

You can avoid this trap by transferring ownership of the policy to the beneficiary or by establishing a life insurance trust to keep the policy and disperse the proceeds to your wishes.

You can still make gifts to the insurance owner (beneficiary or trust) and use your yearly gift tax exclusion to pay the premiums without tax liability.

The proceeds from a life insurance policy owned by a beneficiary are exempt from both estate and income tax.

Similarly, you should avoid making…

*Having your life insurance and designating your partner as the beneficiary. Due to the unlimited marital deduction, the insurance proceeds will not be subject to estate tax when you pass away; however, if your spouse passes away while in possession of the profits, they will be subject to estate tax.

*Having one’s life insured with a third party listed as the beneficiary.

Here’s an example: one parent buys life insurance for their kid’s other parent.

The catch is that the benefit paid to the beneficiary is treated as a taxable gift made by the insurance owner because the policy owner controls the designation of the beneficiary.

Again, this can be avoided if the policy’s ownership is transferred to the beneficiary or a life insurance trust.

You must have a professional draft of your life insurance trust to use it to hold insurance policies. Trust agreements produced by nonspecialists are more likely to contain erroneous wrong wording that does not meet technical standards, leading to the trust’s eventual failure.

Lending against a policy of life insurance. Borrowing against life insurance might be enticing because policy loans are often offered at cheap interest rates and provide a tax-free source of cash.

However, a few pitfalls can arise from using insurance as collateral…

Borrowing against insurance policies can leave your loved ones more vulnerable to financial hardship because it reduces the insurance benefit for which you originally purchased the policy.

The interest on a loan secured by insurance is typically not paid in cash but rather deducted from the insurance payout. A loan with compound interest can increase the value of a life insurance policy if it is not returned. The policy will expire, and you will be required to pay taxes on the difference between the amount of the unpaid loan (a “forgiven debt”) and your basis in the policy, even though you will get no cash.

*The benefit of an insurance policy may be considered taxable income if the procedure is sold after a loan was taken out against it.

Why: A gift of a borrowed-against policy is treated as a purchase by the recipient, who assumes the loan obligation and pays the purchase price in the amount of the supposed loan.

In addition, if the purchase price of a life insurance policy exceeds the donor’s basis in the procedure, the benefit of the policy is considered taxable income to the purchaser under the Tax Code.

Take the case of a parent with a $500,000 life insurance policy but only $100,000 in liquid assets. His policy’s cost base is $60,000. He takes out a loan against the insurance for $90,000, bringing the cash value down to $10,000, and then gives the policy as a gift to a child.

Therefore, the child is considered to have acquired the policy and is responsible for repaying the $90,000.00 loan. The $410,000 payout from the policy will not be tax-free to the child because it is considered ordinary income.

In conclusion, borrowing money always leads to trouble. Thus, you should avoid borrowing money against your life insurance policy.

If you’ve already taken out loans against your life insurance, you should consult a professional to be sure there won’t be any unforeseen issues down the road.

Carson Danfield has been selling his wares “under the radar” for the past eight years in the online marketplace. Even though he is probably unknown to you. You’ve probably been to his websites before and maybe even bought anything from him.

Do you want to find out more about Life Insurance Mistakes? Check out what Carson Danfield says about life insurance traps at Life Insurance Traps.

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