Avoid these life insurance mistakes

Life insurance is fairly straightforward, but the larger your estate is,

the more likely you'll use life insurance for estate tax and business purposes.

That's when things get complicated. Here are some common mistakes to avoid.

Mistake 1: Assume that life insurance proceeds are free of tax.

Yes, the beneficiary receives the proceeds free of income tax. But those

same benefits may be subject to estate tax. Assume you have a $1 million

estate, including your current life insurance. The first $675,000 is exempt

from estate taxes unless you've reduced that exempted amount by making taxable

lifetime gifts. The federal tax on the remaining $325,000 of your estate

is $125,250. Assume you buy a life insurance policy for exactly that amount

to cover the taxes. However, don't forget that the value of that life insurance

policy ($125,250) will now be included in your estate, and your estate will

pay taxes on it — to the tune of an additional $51,353.

Mistake 2: Fail to change ownership properly.

One way to exclude life insurance proceeds from your estate and avoid

the estate taxes is to change who owns the policy. For example, you might

name your adult child as the owner and beneficiary of the policy, with you

as the insured. Another common technique is to transfer ownership of a policy

to an irrevocable life insurance trust. But be wary of tax traps. If you

simply transfer ownership of the policy to the trust or your child, and

you die within three years of the transfer, the proceeds are included in

your estate. You can avoid that by having the child or trust buy the policy

on your life. However, if you're not in good health and the insurance company

won't sell you a policy, you're out of luck. No matter which way you transfer

ownership, you may have to deal with gift tax issues if you give money to

the trust or your child to pay the premiums and they're more than $10,000

per year.

The main thing is to remember to change the ownership and the beneficiary.

In a recent court case, an insured person had transferred ownership of a

$1 million policy to a life insurance trust but failed to make the trust

the beneficiary (he also died within three years of the transfer). The mistake

cost the insured's heirs $450,000 in estate taxes that might have gone to

them if things had been handled properly.

Mistake 3: Misunderstand beneficiary implications.

Simply having someone else own the policy can still cause problems.

A common mistake is to name one spouse as the owner of the policy on the

life of the other spouse, and then name the child (or life insurance trust)

as beneficiary. When the insured person dies and the proceeds pass to the

child or trust, the surviving spouse is deemed to have made a gift of the

full value of the proceeds, minus the $10,000 annual gift-tax exclusion

if no other gifts were made in that year. That's a steep gift tax on a $500,000

or $1 million policy. Have the child or trust be both owner and beneficiary.

Mistake 4: Instruct the life insurance trust.

An irrevocable life insurance trust document that requires the trustee

to use the life insurance proceeds to pay the estate taxes of the insured

could bring the proceeds back into the estate and subject them to federal

estate taxes. Don't issue such instructions (at least not in writing).

Mistake 5: Make improper exchanges.

Increasingly popular are second-to-die policies. These policies pay

upon the death of the surviving spouse, and their premiums are substantially

less than separate policies for the same total amount. However, exchanges

of a couple's separate life policies for a joint second-to-die policy don't

qualify for tax-free exchanges, and any gains that have accrued in the original

policies become taxable income.

Many thanks to Dennis Filangeri, a certified financial planner based

in Metairie, La., and the Financial Planning Association for providing information

for this article.

Zall, Bureaucratus columnist and a retired federal employee, is a freelance

writer based in Silver Spring, Md. He specializes in taxes, investing, business

and government workplace issues. He is a certified internal auditor and

a registered investment adviser. He can be reached at miltzall@starpower.net.