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.
The Building Blocks of Life Insurance
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Life insurance provides protection against financial failure resulting from death. It is an insurance company's guarantee to pay a beneficiary a particular amount of money when an insured dies in exchange for appropriate payment of premiums.
What Is It Intended To Do?
Life insurance serves as refuge in the event of the insured's death. Life insurance gives financial fortification to survivors. It provides dependents with the needed funds to settle financial responsibilities and to compensate for the loss of income due to the insured's death. Life insurance policies are typically bought with a precise objective in mind - to protect a mortgage or an estate, to afford educational expenditures, for retirement, or for donations.
Why Is Life Insurance Essential?
People hold life insurance policies for countless reasons. Among the most frequent are to pay off a mortgage, or personal debts (car loans, credit cards), educational expenses for juvenile children, for beneficiaries to be able to uphold their present standard of living, for child care, for urgent financial needs, and for medical or funeral expenses.
How Can Life Insurance Needs Modify Over Time?
If an individual has completed raising their family, has paid off their mortgage and does not have any chief financial responsibilities, then their life insurance requirements will be less than when they were younger. A person may decide to no longer hold their policy or to decrease their coverage amount to a level just adequate enough to make certain that their survivors have sufficient funds to compensate final expenses upon the insured's death.
How Does Life Insurance Operate?
All aspects of life involve a certain level of risk, whether it is a fire, burglary, car accident, or injury. Insurance provides a way of shifting the financial penalties of particular risks from the person to an insurance company. When a person purchases life insurance, they are put together with other individuals who are comparable in age, sex, and health status, regardless of whether the company advertises a no medical exam term life insurance (http://www.equote.com/li/termlifeinsurance.html) plan.
Actuaries estimate how many people in each group are expected to die in a range of time. The more deaths expected in a group, the more funds will be required to pay death claims, and thus, more money will have to be gathered as premium payments. Since younger people are not as likely to die as older folk, premiums are normally lower at younger ages.
Annually, the insured pays the company for their policy. These funds are called "premiums." The insured also notifies the insurance company of who the beneficiaries of the insurance money are in the event that they (the insured) die. This is referred to as "designating a beneficiary."
If the insured dies during the active period of their policy, the life insurance company (http://www.equote.com/li/term-life-insurance-quote.html) will disburse the insurance money to the designated beneficiaries. Insurance companies can do this because only a small amount of people die annually, while many more individuals pay them premiums. The "risk" of death is allocated among many people to avert a financial loss to the beneficiaries of the people who do actually die.
What Is An Actuary?
An actuary is an individual who is professionally qualified in the technical facets of insurance, principally in the mathematics of insurance, such as measuring premiums, dividends, and appropriate policy reserves. Actuaries help in approximating the price of executing new benefits or benefit improvements and also perform statistical and financial studies. Actuaries in the U.S. attain professional status by passing a set of tests given by the Society of Actuaries (SOA).
Where Does The VA Insurance Program Get Its Actuarial Expertise?
The Insurance Actuarial Staff is situated at the Insurance Center in Philadelphia, Pennsylvania. The Actuarial Staff is accountable for the financial management and actuarial reliability of the life insurance programs that are managed and overseen by the Department of Veterans Affairs Regional Office and Insurance Center.
Among the staff's tasks are the calculation of premiums and dividends, measuring policy values, developing mortality and insurance knowledge studies, implementing suitable reserve levels and financial coverage. The Actuarial Staff is also responsible for the assessment of the financial impact of legislative suggestions that will influence life insurance programs.
The Actuarial Staff is accountable for the groundwork for financial statements released by the VA life insurance programs. These statements display the financial standing of each of the types of life insurance (http://www.youtube.com/watch?v=V5mRvPgZOn8) programs. Annually, independent auditors review these statements to make certain that the statements correctly reflect the financial standing of the various programs.
What Is It Intended To Do?
Life insurance serves as refuge in the event of the insured's death. Life insurance gives financial fortification to survivors. It provides dependents with the needed funds to settle financial responsibilities and to compensate for the loss of income due to the insured's death. Life insurance policies are typically bought with a precise objective in mind - to protect a mortgage or an estate, to afford educational expenditures, for retirement, or for donations.
Why Is Life Insurance Essential?
People hold life insurance policies for countless reasons. Among the most frequent are to pay off a mortgage, or personal debts (car loans, credit cards), educational expenses for juvenile children, for beneficiaries to be able to uphold their present standard of living, for child care, for urgent financial needs, and for medical or funeral expenses.
How Can Life Insurance Needs Modify Over Time?
If an individual has completed raising their family, has paid off their mortgage and does not have any chief financial responsibilities, then their life insurance requirements will be less than when they were younger. A person may decide to no longer hold their policy or to decrease their coverage amount to a level just adequate enough to make certain that their survivors have sufficient funds to compensate final expenses upon the insured's death.
How Does Life Insurance Operate?
All aspects of life involve a certain level of risk, whether it is a fire, burglary, car accident, or injury. Insurance provides a way of shifting the financial penalties of particular risks from the person to an insurance company. When a person purchases life insurance, they are put together with other individuals who are comparable in age, sex, and health status, regardless of whether the company advertises a no medical exam term life insurance (http://www.equote.com/li/termlifeinsurance.html) plan.
Actuaries estimate how many people in each group are expected to die in a range of time. The more deaths expected in a group, the more funds will be required to pay death claims, and thus, more money will have to be gathered as premium payments. Since younger people are not as likely to die as older folk, premiums are normally lower at younger ages.
Annually, the insured pays the company for their policy. These funds are called "premiums." The insured also notifies the insurance company of who the beneficiaries of the insurance money are in the event that they (the insured) die. This is referred to as "designating a beneficiary."
If the insured dies during the active period of their policy, the life insurance company (http://www.equote.com/li/term-life-insurance-quote.html) will disburse the insurance money to the designated beneficiaries. Insurance companies can do this because only a small amount of people die annually, while many more individuals pay them premiums. The "risk" of death is allocated among many people to avert a financial loss to the beneficiaries of the people who do actually die.
What Is An Actuary?
An actuary is an individual who is professionally qualified in the technical facets of insurance, principally in the mathematics of insurance, such as measuring premiums, dividends, and appropriate policy reserves. Actuaries help in approximating the price of executing new benefits or benefit improvements and also perform statistical and financial studies. Actuaries in the U.S. attain professional status by passing a set of tests given by the Society of Actuaries (SOA).
Where Does The VA Insurance Program Get Its Actuarial Expertise?
The Insurance Actuarial Staff is situated at the Insurance Center in Philadelphia, Pennsylvania. The Actuarial Staff is accountable for the financial management and actuarial reliability of the life insurance programs that are managed and overseen by the Department of Veterans Affairs Regional Office and Insurance Center.
Among the staff's tasks are the calculation of premiums and dividends, measuring policy values, developing mortality and insurance knowledge studies, implementing suitable reserve levels and financial coverage. The Actuarial Staff is also responsible for the assessment of the financial impact of legislative suggestions that will influence life insurance programs.
The Actuarial Staff is accountable for the groundwork for financial statements released by the VA life insurance programs. These statements display the financial standing of each of the types of life insurance (http://www.youtube.com/watch?v=V5mRvPgZOn8) programs. Annually, independent auditors review these statements to make certain that the statements correctly reflect the financial standing of the various programs.
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