Twelve Life Insurance Mistakes They Aren t Cheaper By the Dozen

Transcription

1 ESTATE PLANNING THE PRUDENTIAL LIFE INSURANCE COMPANY OF AMERICA Twelve Life Insurance Mistakes They Aren t Cheaper By the Dozen Life is full of mistakes. They are part of life s learning experiences. Eleanor Roosevelt once said, Learn from the mistakes of others. You can t live long enough to make them all yourself. The point is that the wise person learns from the mistakes of those who came before him while endeavoring to avoid them himself. Life insurance is one of the most important purchases that you will ever make. The problem is that life insurance and the rules that impact it are not always user friendly; some rules are traps for the unwary. There is always the potential of making serious and costly mistakes. Others have already made all twelve of the mistakes that we are going to discuss but, with some education and awareness, you need not repeat them. You can learn from others and that is the cheapest way to learn. Mistake Number One: Lack of Education Lack of education, whether it is on the part of your advisor or yourself, has led to many mistakes, including each of the other eleven that follow. Life insurance is not a one-size-fits-all commodity. You need a high degree of comfort with the insurance company, the insurance agent and the products being considered before purchasing anything. Spend the time to do the research first, and you can save headaches later. The key to becoming well educated in any area is to find a good teacher. An insurance agent should do more than sell; he or she should teach and educate. When looking for an insurance advisor, seek recommendations from other professionals such as lawyers and accountants or from satisfied friends. Feel free to ask about the agent s education, experience and background. Make sure he or she is well educated on the services and products you need. In more complex situations, it is important to assemble and work with a team of qualified and knowledgeable advisors who include the accountant, attorney, and insurance agent. Each will add an area of expertise that should help assure success in the task at hand. Mistake Number Two: The Personal Unholy Trinity The so-called unholy trinity exists when three different parties are designated as the owner, the insured, and the beneficiary of a life insurance policy. Should the insured person die under those circumstances, the policy proceeds are considered to be a gift from the owner of the policy to the beneficiary. The beneficiary of a properly structured insurance policy should generally receive the death benefit income, 1 gift and estate tax free; however, Mistake Number Two needlessly exposes the proceeds to gift taxation. Let s look at an example to see why that is the case. Suppose that a wife owns a life insurance policy on her husband s life and names their two children as the beneficiaries. That seems innocuous enough and is all too common. One could reasonably conclude that there is no problem here and that at the death of the husband the children would receive the policy benefits in the usual tax-free manner. Unfortunately, that may not be the case. Back in 1946, a federal court ruled that in a case where the unholy trinity existed at the time of the death of the insured, the policy owner made a gift of the proceeds to the beneficiaries. In the previous illustration, that would mean that at the death of the husband, the wife would be deemed to have made a gift of the proceeds to her children. The rationale is somewhat technical but, simply stated, is this: as long as the insured is alive, the owner of the policy can change the beneficiaries, so there is no completed gift. But 1 Under IRC 101(a). IFS-A Ed. 10/07 Exp. 10/09

2 ESTATE PLANNING 12 LIFE INSURANCE MISTAKES 2 the insured s death does two things: First, it terminates the owner s ability to change the beneficiary. That termination is considered a completed gift, subject to gift taxation. Second, the insured s death matures the policy, making the amount of the gift the full death benefit. Assuming that the death benefit in the example was $2,000,000, we can see the impact of making this mistake. At the death of her husband, the wife will be deemed to have received the $2,000,000 and given each of her children a gift of $1,000,000. That gift is subject to gift taxation. The tax laws may provide some relief but will not necessarily eliminate all of the tax. In 2007, an individual can give as much as $12,000 to as many other individuals as he or she wants, free of gift tax. Since the wife can give each of her children $12,000 gift tax free, the amount of the gift subject to taxation (assuming no other gifts to the children during the year) is $988,000 to each child. In addition to this annual per person exclusion, every individual has a lifetime gift tax exemption of $1,000,000. This means that the first million dollars of the gift, after applying the annual exclusion, will also be tax free. That helps, but it does not eliminate the tax. In the example, the gift that the wife made, after applying the annual exclusion, was two times $988,000 or $1,976,000. After subtracting the $1,000,000 exemption, $976,000 will needlessly be subject to gift tax. To make matters worse, the spouse did not actually receive the death benefit, even though she is deemed to have made a gift of it. That means that she is going to have to use assets other than the insurance proceeds to pay the tax. It may be that the children, wishing to relieve their mother of that financial burden, would give her enough of the policy proceeds to pay the tax. Unfortunately, since that is considered a gift from the children back to their mother, it compounds the problem. estate will not be subject to estate taxation. The insured and the owner can be the same person or the beneficiaries themselves can own the policy. If the estate is subject to estate taxation and the insured is the owner of the policy, the policy proceeds will be subject to estate tax. In that case, it is not wise to have the insured own the policy. A possible solution is to have an entity such as an irrevocable life insurance trust own the policy. In community property states, each spouse is considered to be the owner of 50% of all community property assets. This includes life insurance policies, even if just one spouse is listed as the owner on the application and the policy. If children in these states are the beneficiaries of a policy where one spouse is the insured and deemed to be the owner, the nonowner spouse will still have made a potentially taxable gift to the children when the insured spouse dies. Let s look at a community property example. Assume that the husband is the owner of a policy insuring his life for $1,000,000 and that his wife and three children are each listed as beneficiaries of 25% of the death benefit. At the husband s death, the wife and each child will receive $250,000. If the premiums were paid from community property funds, the wife will be deemed to have made a gift of one-half the death benefit ($125,000) paid to each child. In community property states, where one spouse is the owner, applicant and insured and the children are listed as beneficiaries, premiums should be paid from the owner spouse s separate assets in order to avoid the gift tax problem. What is the solution? Obviously the easiest solution is not to have three different people as owner, insured and beneficiary. That is fairly easy to accomplish in the case of an insured whose

3 ESTATE PLANNING 12 LIFE INSURANCE MISTAKES 3 Mistake Number Three: The Business Unholy Trinity This mistake is similar to Mistake Number Two. However, in this case, a business is the policy owner rather than an individual. The presence of a corporate owner alters the tax consequences of the transaction so that instead of gift tax there is income tax. This form of the unholy trinity may occur when the insured as an owner of a business, uses the business to own the policy, and names a third party, such as a spouse, children, or another shareholder as the policy beneficiary. As mentioned previously, the beneficiary generally receives life insurance death benefits free of income tax under IRC 101(a), but, if there is an unholy trinity, the proceeds will be subject to income tax at the death of the insured. The exact nature of the taxation will depend upon the relationship of the parties involved. If the beneficiary is a shareholder, the proceeds may be taxable as a nondeductible dividend. If the insured is an employee, then the proceeds may be taxable as compensation. This is an area where it is important to seek the advice of knowledgeable advisors. Mistake Number Four: Failure to Name a Successor Owner When we think of the assets that we own, we generally think of assets such as stocks, bonds, real estate, and personal property. All too often we fail to think of an insurance policy as an asset. Failure to do so is Mistake Number Four. If an individual owns the traditional assets mentioned above, those assets would be subject to probate at the time of the owner s death. A life insurance policy is no different. If the owner and the insured are two different people and the owner dies first, the policy ownership has to pass to a successor owner until the death of the insured results in the proceeds being paid to a beneficiary. Probate, which is the procedure by which the ownership passes to that next owner, can cause unneeded costs, frozen assets, and the loss of time. It can also negate many of the advantages that insurance enjoys. At the death of an owner, the policy passes as a probate estate asset to the next owner either by will or by intestate succession, if no successor owner is named. This could cause ownership of the policy to pass to an unintended owner or to be divided among multiple owners. If the insured inherits the policy, at his or her subsequent death, the policy proceeds may be subject to inheritance or estate taxation. Additionally, in some states, once the policy is part of the probate estate, it becomes accessible to the creditors of the decedent/owner. The solution is quite simple: where the insured and owner are different individuals, either name at least one successor owner or have an entity such as a trust own the policy. Mistake Number Five: Naming the Estate as Beneficiary The general rule is to never name an estate as the beneficiary of an insurance policy. This can be a needless and costly Mistake Number Five. If the insured s estate is the beneficiary, the policy proceeds may needlessly be subject to probate, creditor s claims, and estate or inheritance taxes (possibly both) at the state and federal levels. The protection of life insurance from the claims of creditors takes many forms and varies from state to state so it is important to obtain advice from legal counsel concerning your specific situation. Generally, insurance death benefits actually paid to a named beneficiary are exempt from attachment by the creditors of the deceased insured, but if those policy proceeds are paid to the insured s estate, they are no longer considered life insurance. Instead, they are considered cash in the estate, subject to the rights of creditors.

4 ESTATE PLANNING 12 LIFE INSURANCE MISTAKES 4 Any assets that become part of the decedent s estate, including insurance policies and their death benefits, are also potentially subject to the time and costs of probate. If the estate is named as beneficiary, the proceeds will pass to the decedent s heirs either by will or by intestate succession. That could result in the proceeds passing to unintended beneficiaries, including minors. The estate may become the beneficiary unintentionally. If only one beneficiary is named but he or she predeceases the insured, then, by default, the insured s estate becomes the beneficiary. The solution is to name both primary and secondary beneficiaries. If there are (1) no estate or inheritance tax issues, (2) no concerns about a creditor reaching the policy proceeds, and (3) no concerns that the proceeds will be subject to probate, then naming the estate as beneficiary might be appropriate. Otherwise, it is generally more advantageous to name beneficiaries other than an estate. Mistake Number Six: The Three-Year Inclusion Rule If, at death, the insured is the owner of, or has any incidents of ownership in, a life insurance policy, the entire death benefit is subject to estate tax. If the insured s total estate value, including the life insurance death proceeds, is less than the estate tax exclusion amount ($2,000,000 in 2007 and 2008) or is passing to a surviving spouse under the unlimited marital deduction, there should not be a federal estate tax. In this situation, it may be desirable for an insured to own his or her policy. However, if an insured s estate is large enough to be subject to estate taxation, ownership of his or her policy will trigger unnecessary estate taxation. Unfortunately, the insured is often the owner. What does the owner/insured do when he or she discovers that ownership of the policy creates a tax problem? The most obvious solution is to give the ownership of the policy to another person or to a trust. That sounds like a quick and easy solution, but it could be Mistake Number Six. The Internal Revenue Code contains an inclusion rule that provides that if an insured owns a policy on his or her life and gives the policy to another person, trust or entity and then dies within three years of the transfer, the policy proceeds will be included in the estate of the insured and subject to estate taxation. This inclusion rule captures transfers involving more that just direct policy ownership. Another provision of the Code provides that if the decedent/owner possessed any incidents of ownership in the policy at the time of his or her death, the death benefit is subject to estate tax. Incidents of ownership include the right to: (1) change the beneficiary, (2) surrender or cancel the policy, (3) assign the policy, (4) revoke an assignment, (5) pledge the policy for a loan, or (6) obtain a policy loan. Because of the interaction of these two Code sections, when the insured transfers the policy, these rights must be relinquished, and the transferring owner must live more than three years after the relinquishment or transfer in order for the policy proceeds to escape estate tax inclusion. The three-year inclusion rule does not apply to a bona fide sale for adequate consideration. However, if the transaction is structured as a sale, the transfer-for-value rule will apply unless the transfer is structured to fit within one of the allowable exceptions. We ll discuss the transferfor-value rule further in Mistake Number Seven, but first let s see how a non-gift transfer of the policy and all incidents of ownership can be a solution to the three-year inclusion rule. The three-year rule often comes into play when an owner/insured gives an existing policy to an irrevocable life insurance trust (ILIT). Since the three-year inclusion rule impacts only gifts, the transfer can be structured to be a sale to the trust as long as the trust is wholly owned by the policy owner/insured. Many advisors feel that this will avoid both the three-year inclusion rule and the transfer-for-value rule because the trust and the policy owner are viewed as the same person; hence, the owner is, in effect, selling it to himself.

5 ESTATE PLANNING 12 LIFE INSURANCE MISTAKES 5 Another solution is to purchase term insurance to cover the three-year period during which the transferred policy would be subject to estate taxation. Mistake Number Seven: The Transfer-for-Value Rule Generally speaking, life insurance proceeds are not subject to income taxation, meaning that the policy beneficiary does not pay income tax on the amount of insurance benefit that he or she receives as a result of the death of an insured. 2 However, if, after the initial purchase of the policy, either the policy itself or an interest in the policy is transferred for valuable consideration, the transfer-for-value rule is triggered. Under the transfer-for-value rule, the life insurance death benefit is subject to income tax unless the transfer falls into one of several exceptions. This is Mistake Number Seven. The rationale behind this rule is the generally accepted principle that one should not be able to purchase an insurance policy on the life of another for a profit motive. However, the rule catches a much broader range of transactions that are not quite so obvious. A number of examples of the impact of the transfer-for-value rule can be illustrated using a business continuation cross purchase agreement. In a life-insurance-funded cross purchase agreement, each business owner typically owns, and is the beneficiary of, a life insurance policy on the life of every other owner. At the death of one of the business owners, each of the others is obligated to use all or a portion of the insurance proceeds to purchase the decedent s portion of the business. While that seems quite simple, the transfer-for-value rule can be a trap for the unwary in a number of ways. First, money does not need to change hands for the rule to apply. A mutual or reciprocal promise can be enough to cause the transfer-for-value rules to apply. Simply changing the ownership or beneficiary designation of an existing policy in order to fund a cross purchase buy-sell arrangement will trigger the rules because the promise to buy the stock at the shareholder s death is considered valuable consideration. The very nature of a cross purchase agreement can trigger the rule in other ways. Let s suppose that Jim, Bill and John are owners of a business that has implemented a cross purchase agreement funded with life insurance. At Jim s death, Bill and John receive the proceeds of the policies that each of them have on Jim s life and purchase his interest in the business from his estate or his heirs. Now that Jim is deceased, his estate owns the policies that he had on the lives of Bill and John. Jim s heirs usually have no use for those policies, but Bill and John do. Jim s estate will most likely sell the policies to Bill and John. That sale triggers the transfer-for-value rule, causing at least some portion of the proceeds to be subject to income tax at the next death. The policy does not need to have cash value to be subject to the rule. The death benefit of a term policy can just as easily be subject to taxation under this rule. The rule is quite broad and, once triggered, can apply for the life of the policy, not just for three years as was the case in Mistake Number Six. Now that we understand the basics of the rule, is there a way to avoid it? Fortunately, there are exceptions to the rule. If a transfer falls under one of these exceptions, even though the transfer is for valuable consideration, the death benefit proceeds will not be subject to income tax. These statutory exceptions include transfers made to the following exempt transferees: The insured, A partner of the insured, A partnership in which the insured is a partner, or A corporation in which the insured is an officer or shareholder. Also exempt are transfers where the individual or entity receiving the basis in the policy is determined in whole or in part by reference to the basis of the transferor. This is called the 2 Under IRC 101(a).

6 ESTATE PLANNING 12 LIFE INSURANCE MISTAKES 6 carryover basis exception. This exception applies when the transfer of a policy is by gift rather than for value. What looks like a gift, though, may not necessarily be a gift. That brings us to Mistake Number Eight. Mistake Number Eight: The Gift of a Policy Subject to a Loan The gift of a policy with an outstanding loan is a common occurrence. In fact, transferors often borrow from a policy before transferring it in order to reduce its value for gift tax purposes. But, as with any technique, too much of a good thing can lead to an undesired tax result. Remember that the transfer-for-value rule, while it does not apply to gifts of policies, does apply if there is any form of consideration involved in the transfer. The transfer of a policy subject to a loan, even by gift, discharges the transferor s loan obligation; therefore, the transferor is treated as having received valuable consideration in an amount equal to the forgiven debt. If the loan against the policy is less than the transferor s basis 3 in the policy, there is no transfer for value issue. As long as the basis exceeds the loan, the carryover basis exception to the transfer-for-value rule applies. On the other hand, if the amount of the loan exceeds the transferor s basis, the transaction fails to qualify for the carryover basis exception to the transfer-for-value rule, thus subjecting a portion of the death benefit to income taxation. The solution is to make sure the loan amount never exceeds the basis in the policy at the time of transfer. If it does, the loans should be paid down prior to transfer. Problems with loans and policy transfers are not limited to transfer-for-value issues. They can negatively impact other policy transfers, as demonstrated in Mistake Number Nine. Mistake Number Nine: Exchanging a Policy Subject to a Loan For a number of reasons, there may be a need to exchange an existing life insurance policy for a new one. Very little in life is static. Families, finances, goals and objectives can all change. Life insurance policies also change, as better and more efficient policies are often introduced to the market. Congress recognized that these changes do occur and addressed the need by enacting Section 1035 of the Internal Revenue Code. That Section provides that if certain requirements are met, an exchange of one policy for another may be made without any tax implications at the time of the transfer. One of the requirements for obtaining the full tax advantages of a 1035 exchange is that no money or property other than like-kind can be received. If it is received, income will be recognized to the extent of that other property. Policy owners must be particularly careful when an exchange involves a policy with a loan against it because, if the loan is extinguished as part of the exchange, the loan amount is treated as if cash were received, and any gain in the contract will be recognized up to the amount of the loan. The most common solution is to arrange for the new policy to be subject to the existing policy loan. In the circumstance where that cannot be done, the policy owner should use funds independent of the policy that is being exchanged to pay off the loan on the old policy prior to the exchange. Mistake Number Ten: Pledging a Modified Endowment Contract Because life insurance enjoys a number of tax benefits, including the tax-free build-up of cash value inside the policy, Congress has enacted limits on how much cash can be placed in a policy and still permit it to qualify as life insurance. One of those limits is imposed by the Modified Endowment Contract (MEC) rules. The definition of a MEC is quite technical, but it essentially places a limit on the amount of cash, 3 Generally, the amount of premiums paid has been considered the transferor s basis for this purpose; however, in some rulings involving a policy transfer, the IRS has required a reduction of basis for the cost of life insurance during the time the contract was held.

7 ESTATE PLANNING 12 LIFE INSURANCE MISTAKES 7 in the form of premiums, that can be placed in the policy in its early years. Exceeding that limit will cause the life insurance policy to be classified as a MEC, causing a loss of some important income tax benefits. One of those lost benefits involves the treatment of loans and withdrawals of policy cash surrender values. The general rule is that as long as a life insurance policy is in force, loans and withdrawals that do not exceed basis may be taken from the policy s cash values income tax free; however, classification of a policy as a MEC changes that. Distributions and loans from a policy classified as a MEC are subject to income tax to the extent that the loan or withdrawal exceeds the policy basis. 4 In addition to the income tax, a ten percent penalty tax will be imposed unless the recipient is disabled, is over the age of 59½, or the distributions are part of a series of distributions that meet the special requirements in the Internal Revenue Code. Can that result be avoided by pledging the policy as security for a loan rather than borrowing from the policy? The answer is no. If the owner of a MEC assigns or pledges any portion of the value of such a contract, the amount of the assignment or pledge will be treated as a disbursement from the policy. That means that, to the extent there is gain in the contract, the pledged amount will be subject to ordinary income taxation in the same manner as if the loan or withdrawals had come from the policy itself. The solution is to pledge other assets, if at all possible. Mistake Number Eleven: Taking Policy Withdrawals within the First Fifteen Years Two characteristics of life insurance allow it to be an efficient and cost-effective method of funding nonqualified compensation plans or to help serve as a retirement income supplement. The first is that cash value build-up in a policy is not subject to income taxation. The second is that those cash values can be withdrawn (to the extent of basis) or borrowed, free of income taxation. It is important to understand that withdrawing or borrowing cash values may cause a decrease in the policy s death benefit. In order to prevent abuse of the tax-favored treatment of life insurance, the Internal Revenue Code includes a provision sometimes referred to as the cash-rich rule or the recapture ceiling test. Violating that rule is Mistake Number Eleven. Generally, the cash-rich rule applies to policies issued after In basic terms, a policy is considered cash rich when the cash value nears the maximum amount allowable under the Code s definition of life insurance. According to the cash-rich rule, anytime there is a cash distribution from the policy that results in a reduction of the death benefit within the policy s first fifteen years, the policy must be tested to determine a recapture ceiling. The withdrawal is then taxable up to the least of the following three amounts: (1) the recapture ceiling; 5 (2) the gain in the policy; or (3) the amount of the withdrawal. Cash-rich testing generally affects policies that have been heavily funded. So, the more heavily funded the policy, the more likely the cash-rich rules will cause a distribution to be taxable. If the answers to all four of the following questions are in the affirmative, then seek advice before withdrawing funds from the policy: Was the policy issued (or exchanged) after 1984? Is the policy a non-mec? Has the policy been in force for less than 16 years? Will the withdrawal cause a reduction in the death benefit? 4 See footnote 3 regarding basis. 5 The recapture ceiling is a dollar amount captured using one of the required methods set forth in Section 7702 of the Internal Revenue Code. The method for determining the recapture ceiling differs depending on whether the distribution occurs in years one through five or in years six through fifteen.

8 ESTATE PLANNING 12 LIFE INSURANCE MISTAKES 8 Mistake Number Twelve: Failure to Do Policy Reviews At Mistake Number Nine, change was discussed as a reason for considering the exchange of an existing insurance policy. Not all change requires a new policy, but it is an important reason for reviewing existing policies. As people s circumstances change so do their needs as well as their goals and objectives. Minor children grow up, children and grandchildren are born or adopted, marriages and divorces happen and people die. All beneficiary and ownership designations should be checked periodically to make sure that they are in line with current needs. Changes in personal and family circumstances are not the only reason for policy reviews. Life insurance and other financial products also change. New ones become available, old ones may not perform as originally presented, costs of insurance may be reduced and so forth. State fiduciary statues impose duties upon corporate trustees not only to review but also to manage life insurance policies. Those statutes provide sanctions for failure to do so. Generally speaking, it is a good idea to review policies every three years, as well as whenever there is a change of circumstances or an occurrence such as those mentioned above that would warrant an immediate review. Conclusion No one would argue that a listing of twelve mistakes is inclusive of all of the errors that could be made with life insurance. A comprehensive list is not the purpose of this brochure. Rather it is hoped that an awareness of these limited issues has highlighted the fact that protecting one s family and business by means of life insurance is very serious and should be done with considerable thought as to the details. The failure to understand these details and work within the rules can have serious consequences that may prevent a well-intentioned plan from achieving its purpose. Insurance is not just a commodity; it is an integral part of a package of personal and financial protection that requires care in its implementation. The role of competent advisors is important and should not be overlooked. What might have been enough insurance in prior years may not be adequate today as wealth grows and inflation takes its bite. Conversely, it also could be that an old insurance policy is no longer needed but could be used to fund other financial products that might now be more appropriate. This material is designed to provide general information in regard to the subject matter covered. It contains references to concepts that have legal, accounting and tax implications. It is not intended as legal, accounting or tax advice. Consult your own attorney and/or tax advisor for advice regarding your particular situation. Like most insurance policies, our policies contain exclusions, limitations, reductions of benefits and terms for keeping them in force. Your licensed financial professional will provide you with costs and complete details. Life insurance is issued by The Prudential Insurance Company of America, Newark, NJ and its affiliates. All are Prudential Financial companies, and each is solely responsible for its own financial condition and contractual obligations. Prudential, Prudential Financial, the Rock logo, and the Rock Prudential logo are registered service marks of The Prudential Insurance Company of America and its affiliates The Prudential Insurance Company of America 751 Broad Street, Newark, NJ IFS-A Ed. 10/07 Exp. 10/09