By Boyce F. Lowery, CLU®, ChFC®
On the surface, life insurance seems pretty simple. You pay an insurance company to ensure that your business, business partner, or loved ones will be taken care of financially should anything happen to you. Or maybe your business is using life insurance as part of a deferred compensation plan or as a part of a succession planning strategy. Perhaps you own life insurance as a special asset to provide you tax-free income down the road and to provide you asset protection from potential creditors. All of these reasons and many others make sense as to why one buys life insurance. However, like an iceberg, there is a whole lot of trouble beneath the surface that can cause significant damage to the unwary.
Life insurance can actually be incredibly complicated. Between the different types of policies, various riders and features available, and all of the regulations, there is a lot that can go wrong. It doesn’t surprise me when people make mistakes with their life insurance, especially if they’re trying to handle it on their own or with an inexperienced advisor or one who tries to practice in multiple financial disciplines like property casualty insurance, financial planning, investment advice, etc. There is simply too much to know when it comes to life insurance planning. One doesn’t go to their family doctor when it’s time for serious advice concerning one’s heart, kidneys, lungs, etc. You go to an expert in the field for which you need advice and recommendations.
I don’t want you to go through the hassle of unnecessary and costly insurance mistakes. To save you the trouble and expense, here are just some of the areas where people are prone to eventually pay the price for not working with a life insurance expert when they purchased their life insurance policies. The points made below are intentionally simplistic and are not intended to provide you tax, investment planning, or legal advice. We would be happy to meet with you personally to examine your specific situation to see how we can help you.
One big mistake I see is being either over- or underinsured. If you are underinsured, your business or family will not have the financial resources they need to make ends meet when you pass away. If you are over-insured, you could be unnecessarily putting your money toward premiums when it would be better used elsewhere. You can KNOW whether you have the right amount of insurance. It’s all in the numbers.
2. Not Conducting Periodic Policy Reviews
It is important to review your life insurance policies from time to time to make sure they are still meeting your needs. You may be eligible to take advantage of special policy options for which you are unaware. Maybe one or more of your policies can be exchanged, without taxation, for another policy that better meets your needs while improving your financial position.
3. Not Updating Health or Avocational Improvements
Health issues, tobacco use, and avocational risks can all affect your policy and premiums because they affect the risk class for which you are being charged for your life insurance. These items can put you into a higher risk class, which increases policy expenses. So, if you quit your hazardous avocation or quit smoking, make sure the change is reflected in your life insurance policy as soon as you qualify.
One more point to make is that different life insurance companies treat perceived risks differently. For example, the use of chewing tobacco will put you in the tobacco usage risk class with most life carriers, but not all. Vaping, likewise, will put an insured in the tobacco usage risk class with nearly all carriers, but not all. Flying an experimental aircraft will cost more for one’s insurance with almost all insurance companies, but not all. If you are 5’ 10” and weigh 200 lbs., you may qualify for the very best risk class with a few carriers, but not with others. The point is, you need the assistance of a knowledgeable independent life insurance advisor to navigate your purchase and ongoing service needs when it comes to life insurance.
4. Failing to Account for Conversion (Policy Exchange) Language
Some people get themselves into trouble when they don’t pay attention to the conversion (policy exchange) language in their term life policies. Ignoring this language can be very costly down the road. Most term life policies limit you to only one product being available for conversion (exchange), and that product is then usually very costly by design because the insurance carrier determined to make it so. In this case, the carrier has determined that most people who convert do so because they cannot qualify for a new term policy due to health reasons. Allowing them to convert to a permanent plan is helpful, but the policy owner would be better served to be able to pick any permanent plan sold by the carrier to get far better value in the permanent plan. It is very important to understand your conversion (exchange) options when buying term life insurance.
5. Failing to Consider a Life Settlement Prior to a Policy Lapse
A life settlement is the sale of an existing insurance policy for more than the cash surrender value but less than the death benefit. Oftentimes policy owners who no longer need or want their policies simply let them lapse without first checking to see if they can get more from a life settlement transaction. There is a multibillion-dollar market for the sale and purchase of unwanted life insurance policies. This applies to both permanent and term policies. The value of an unwanted policy for the policy owner is determined by the pricing of the existing policy, the age and health of the insured (life expectancy), and other factors. Generally, the life expectancy of the insured would need to be less than 15 years or so for there to be any interest from the Life Settlement industry.
6. Creating the Goodman Triangle
Named after a 1946 court case, this is also called the “unholy trinity” when it comes to a life insurance policy. It happens when the policy owner, the insured, and the beneficiary of a given policy are three separate individuals. When this mistake is made, the death benefit will count as a taxable gift to the beneficiary from the policy owner at the date of death of the insured. This is a very common problem looming for the unwary.
7. Violating the Transfer-for-Value Rule
This is another way that the rich tax benefits of life insurance can be negated. If you sell a life insurance policy (or trade its benefits for something of value), then the death benefit may become taxable in full or in part. Thus, be very careful when transferring policy ownership or benefits in order to avoid the Transfer-for-Value Rule.
The exceptions to the Transfer-for Value Rule are:
- Policy transfers to the insured on the policy
- Policy transfers to a partner of the insured on the policy
- Policy transfers to a partnership in which the insured on the policy is a partner
- Policy transfers to a corporation in which the insured on the policy is an officer or shareholder
- Policy transfers in which the recipient’s cost basis in the policy being transferred is calculated in reference to the cost basis of the transferor (This exception is usually applicable in tax-free corporate reorganizations, where the old company transfers the policy to the new one.)
8. Naming Your Estate as Beneficiary
Life insurance proceeds usually go directly to the beneficiary and thus avoid probate. Probate is the lengthy legal process in which an estate pays off its debts and is then divided among heirs. If the beneficiary of a life insurance policy is an estate, then the money will be tied up for the entire process of probate and inaccessible by those who otherwise may have been the recipient of the benefits in a timely manner. Further, the probate process in your state may not provide that your intended beneficiary will be the recipient of the funds once the probate process is complete.
9. Failure to Provide Crummey Notices in a Timely Manner
A landmark tax court case was decided way back in 1968. The party to the tax court case had a last name of Crummey; hence, the name “Crummey Notice.”
Life insurance death benefit proceeds, when the policy is owned by the insured, are a part of the insured’s estate at death. To avoid the death benefit amount being counted as a part of the estate (which might cause (additional) estate taxes to be payable depending on the size of the total estate value and the estate tax exemption amount available at the death of the insured), a common strategy is for the policy to be owned by an Irrevocable Life Insurance Trust (ILIT).
In order for the premium payments to be made by the policy owner (the ILIT), the grantor of the trust makes an annual gift to the ILIT. In order for the gift to be considered a present interest gift, the beneficiaries of the trust must be notified of the gift and given sufficient time to request the gift be transferred from the trust to them (the Crummey Notice). If the beneficiaries fail to request the proceeds of the gift made to the trust for their benefit in a timely manner, then the trustee will use the proceeds to pay the life insurance premium on the policy owned by the ILIT.
Failing to follow the very strict rules of Crummey Notices can lead to the death benefits being included in the estate and therefore subject to potentially enormous taxes.
10. Inadvertent Change to Modified Endowment Contract Status
The IRS has limits on life insurance premiums paid during the first seven years of a permanent life insurance policy, or after a material change to the policy. If you overpay or pay your premiums early, it could cause your policy to obtain modified endowment contract (MEC) status. Though there are reasons to purchase an MEC, having your policy inadvertently become an MEC can be detrimental indeed. If a life policy is or becomes an MEC, the tax status is different for that policy than a non-MEC policy.
Any loans or withdrawals from an MEC are taxed on a last-in, first-out basis (LIFO) instead of FIFO. Therefore, any taxable gain that comes out of the policy is reported before the nontaxable return of principal. Furthermore, policy owners under the age of 59.5 must pay a 10% penalty for early withdrawal on any interest received (interest is paid out first).
11. Failure to be Compliant with IRS Code Section 101(j)
There are special rules that apply to employer-owned life insurance policies, which are spelled out in Section 101(j) of the Internal Revenue Code. It is important to maintain compliance with these rules because failure to do so can result in a portion of the death benefit becoming taxable for any employer-owned policy purchased on or after August 17, 2006 (or where a material change occurred after that date to a policy predating August 17, 2006).
This is an area where billions, if not trillions, of dollars of life insurance is in force and the death benefits will be subject to income taxation at the death of the insured. If you own a business that owns one or more life insurance policies, it is imperative that you work with a life insurance professional who is an expert in business and life insurance matters to avoid the icebergs hidden beneath the surface.
12. Failing to Manage Policy Loans
While the ability to take a tax-free loan against your life insurance policy can be a really useful benefit, it can also be dangerous if you don’t fully understand the terms of the loan provisions and then manage your loans wisely. If the policy ever lapses, you will owe taxes on all of the loan proceeds and the accrued interest thereon to the extent the outstanding loan balance exceeds your tax basis in the policy. If you pass away with an outstanding loan, the reduced benefit that your family or business receives net of the loan repayment may not be sufficient for their financial needs.
13. Failing to Purchase a Policy with an Overloan Protection Rider
It is commonplace for a policy owner to have purchased a policy with the intent of using it to provide tax-free cash flow in the future. However, most consumers are unaware of a very important policy rider that is available on some policies. This rider is commonly called an Overloan Protection Rider. It is a free rider at inception and only carries a fee when it is used at some point in the future. The fee, if ever imposed, is de minimis when compared to the potential taxes saved.
The provisions of this rider will vary from company to company, but typically the policy must have been in force for 15 years and the insured has reached age 75 before the benefits of the rider become available. Succinctly, the rider can eliminate the risk of a policy lapsing from having a loan become too large to be supported by the policy, which would then cause financial devastation from a very large tax bill.
Most indexed universal life policies have an Overloan Protection Rider of some sort, but very few whole life policies make this rider available. There is at least one major provider of whole life insurance that does have this rider, and its importance cannot be overstated.
14. Late Payments for Guaranteed Universal Life Policies
With a guaranteed universal life (UL) policy, making premium payments late can spell disaster. Some life insurance policies that provide a guaranteed death benefit at a guaranteed price have a provision whereby the guarantees otherwise provided are forfeited if the payment is not made prior to the end of the grace period, even if the policy has accumulated policy values.
15. Failure to Properly Fund and Manage Universal Life Policies
Universal life insurance policies, without the guaranteed rider mentioned above, are somewhat complex and require understanding and management. These types of policies are typically purchased when one wants to accumulate cash on a tax-advantaged basis in addition to acquiring the insurance coverage desired. You wouldn’t purchase an investment asset and forget about it (I hope). Neither should you fail to pay attention to a universal life insurance policy you own. Far too often, I see policies in force that are significantly underfunded.
The cost of insurance, policy expenses, interest crediting methodology, loan provisions, and more are all available to see and examine. The actual mortality charges are based on an annually renewable term design, meaning that the cost of the insurance increases annually, if not monthly. Universal life policies have flexible premiums, meaning the policy owner can choose, within limits, how much to pay and when. Unfortunately, paying a premium amount at the minimum initial requirement or anything close to this amount can spell eventual disaster with either the policy lapsing for insufficient cash values or the policy owner having to pay MUCH higher premiums to maintain coverage.
16. Failure to Structure Buy-Sell Life Insurance Policies Correctly
Life insurance is often purchased to fund buy-sell agreements for business owners. Commonly, I see the buy-sell agreement set up in such a way that the surviving owners don’t receive a step up in their tax basis when the deceased owner’s ownership is purchased. This is a significant and potentially very costly error that should be remedied sooner rather than later.
17. Failure to Request a Policy Be Backdated
Many people end up paying higher premiums because they don’t realize that backdating is possible or don’t understand it well enough to know that it is a completely legal and acceptable practice in the life insurance industry. Insurance premiums are driven by age, so by backdating a policy, you may be able to get a lower premium payment than would otherwise be possible. A competent advisor can help you determine if backdating your policy is a good idea.
18. Obtaining Only One Offer
If you have underwriting issues, such as a health problem or a perceived dangerous avocation, a competent advisor will work with you to obtain multiple offers when the effort makes sense. Life insurance companies all have their own underwriting guidelines and may have different reinsurers as well. The more unique your situation, the more important it is to get offers from various companies so that you can ensure you are getting the best value based on your unique underwriting profile.
19. Not Recognizing Life Insurance as a Financial Asset
A good financial plan looks at your entire life and utilizes all the tools available to help you achieve your goals. Often, I see people failing to take life insurance into consideration as a financial planning tool. Especially when it comes to retirement planning, life insurance can be a very effective tool if you understand how it integrates with the other areas of your financial life. Many investment advisors recommend the 4% rule of thumb when it comes to retirement spending. These advisors suggest that, to avoid running out of money during retirement, one shouldn’t spend more than 4% of their retirement portfolio plus an increase for inflation each year. Personally, I don’t like rules of thumb, but I can tell you that those retirees who have planned their retirement properly will have included life insurance as an asset class. Properly designed, this strategy can allow one to remove 50% or more additional funds each year without additional risk than when the portfolio doesn’t include a properly structured life insurance plan.
20. Waiting Too Long
You don’t want to wait too long to buy life insurance. Your premiums are based on the risk class you qualify for as well as your age and gender. The older you get, all things being equal, the higher the life insurance premiums will be. In fact, if you wait too long, you may find yourself worrying about being able to get any insurance at all, much less securing lower premiums.
In my many years of working with people, countless times I’ve found individuals who would give most anything to be able to secure the life insurance they need. They either procrastinated or believed, like so many others, that they would be healthy indefinitely. Unfortunately, it doesn’t work that way.
21. Going Solo or Relying on Uniformed Advisors
One way to avoid all of the mistakes listed here and many others is to work with an experienced independent life insurance professional who is a specialist. You don’t go to a dentist for his knowledge of cancer or a heart condition, and you shouldn’t go to your property casualty agent, financial planner, or investment advisor for your life insurance needs. Though they may be an expert in their field of endeavor, they don’t know what they don’t know when it comes to life insurance. With over 40 years in the life insurance industry personally and with the additional years of experience of our team, we at Suncrest Advisors can be your trusted guides as you choose and implement the best life insurance strategy for your situation. Feel free to call us at 888-827-0146 to set up a complimentary no-obligation consultation.
Boyce Lowery is a 42-year veteran and established expert in the insurance industry. As the managing partner of Suncrest Advisors, he, his partner, and their associates all aim to provide financial security and peace of mind to business owners, executives and professionals, and high net-worth individuals across the United States. Along with more than four decades of experience, Boyce is a Chartered Life Underwriter® (the premier designation for insurance professionals signifying specialized knowledge in life insurance and estate planning) and a Chartered Financial Consultant® (known as the advanced financial planning designation). To learn more, visit https://suncrestadvisors.com/ or connect with Boyce on LinkedIn.