More than three years ago, we first published an in-depth look at 5 mistakes in life insurance planning. Despite shifts in politics and the economy, tax code changes, and other variables of life, the facts remain the same. In personal life insurance planning, particularly as part of estate planning, even minor oversights can lead to major tax problems.
Recognizing that efforts to reduce cost in the short term could lead to problems, we’re resharing this important information on 5 key trouble spots in life insurance planning. The report was first published on WRNewswire and WRMarketplace by the Association for Advanced Life Underwriting® as part of the Essential Wisdom Series. You can read the full report here on Deferred Compensation News.
Your Checklist: 5 Mistakes in Life Insurance Planning
- Failure to Qualify for Annual Exclusion Gifts
- Improper GST (generation-skipping transfer) Tax Exemption Allocation to ILITs (irrevocable life insurance trusts)
- Incidents of Ownership in ILIT-Owned Policies
- Failure to Understand Implications of a MEC (modified endowment contract)
- Creation Of “Taxable” 1035 Policy Exchanges
Overview of 5 Life Insurance Planning Mistakes
For more information along with practical insights and examples, be sure to read the complete article, available here as a PDF download.
Failure to Qualify for Annual Exclusion Gifts
ILITs are not “set it and forget it” propositions. People may rely on the annual exclusion from gift tax (“annual gift exclusion”) to make gifts to their irrevocable life insurance trusts to fund premiums.1 A gift only qualifies for the annual gift exclusion if the recipient has a “present interest” in the gift, and gifts to ILITs typically do not satisfy this requirement.
Improper GST Tax Exemption Allocation to ILITs
The annual exclusion from generation-skipping transfer (GST) tax requires that the trust receiving the gift must (1) benefit only one individual during his/ her life (who is a skip person for GST tax purposes (e.g., a grandchild)) and (2) the trust assets must be paid to that individual during life or be includible in his gross estate at death. Gifts to typical ILITs will not qualify for the annual GST tax exclusion.
Incidents of Ownership in ILIT-Owned Policies
An insured that retains any “incident of ownership” over a policy at death, whether individually or through a trust, will trigger inclusion of the policy proceeds in his or her estate. “Incidents of ownership” extend well beyond the holding of title to a policy and include, for example, the insured’s ability to change beneficiaries or to access policy cash value, including the power to pledge the policy for a loan (e.g., coverage on a business owner pledged as collateral for a line of credit).
Failure to Understand Implications of a MEC
For most life insurance contracts, withdrawals of policy cash value by the policy owner are not taxable, up to the owner’s tax basis in the policy. A different rule applies to life insurance contracts classified as modified endowment contracts (MECs).2
Creation Of “Taxable” 1035 Policy Exchanges
Code §1035(a) allows the exchange of one life insurance contract for another, generally without the recognition of gain or loss upon the exchange (a “1035 exchange”).This provision allows the deferral of taxation for individuals who merely exchange one policy for another better suited to their needs. 1035 exchanges are popular because they permit clients to adapt their long-term life insurance planning to changed economic and family circumstances, but they must be carefully implemented with full awareness of related issues and caveats that may apply.
Life insurance remains one of the best ways to protect your family, your business, and your wealth. Taking advantage of it strategically requires knowledgeable guidance and expertise.
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2 A MEC is a life insurance contract that: (1) is entered into or materially changed after June 21, 1988, and (2) fails the “seven-pay test” (see Code §7702A). A policy fails this test if at any time in the first seven years, the total premiums paid for the policy exceed the total net level premiums that would have been paid up to that point for a fully paid-up policy requiring seven level annual premiums (see Code §7702A(b); §7702A(c)).
This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, accounting, legal or tax advice. Any tax advice contained herein is of a general nature. You should seek specific advice from your tax professional before pursuing any idea contemplated herein.
Securities offered through Lion Street Financial, LLC (LSF) and Valmark Securities, Inc. (VSI), each a member of FINRA and SIPC. Investment advisory services offered through CapAcuity, LLC; Lion Street Advisors, LLC (LSF) and Valmark Advisers, Inc. (VAI), each an SEC registered investment advisor. Please refer to your investment advisory agreement and the Form ADV disclosures provided to you for more information. VAI/VSI, LSF and BDO Alliance USA are non-affiliated entities and separate entities from Fulcrum Partners and CapAcuity, LLC. Unless otherwise noted, VAI/VSI, LSF and BDO Alliance USA are not affiliated, associated, authorized, endorsed by, or in any way officially connected with any other company, agency or government agency identified or referenced in this document.