Life Insurance Estate Planning: 7 Costly Errors to Avoid
The Federal Estate Exemption will increase to $12.92 million per individual (or $25.84 million per couple) in 2023. Currently, the exemption is large enough that most people's estates will safely avoid any tax implications when they pass away.
But, in less than 3 years, this amount will reduce to roughly $6 million, and if your is estate worth more than the exemption, your heirs will owe on the assets you leave behind.
These taxes must be paid in cash within 9 months of the estate owner’s passing, or the IRS can begin assessing penalties and seizing property. It's also important to note that some states levy their own inheritance and estate taxes too.
To avoid these obligations, life insurance is used as a legal method of avoiding a large tax burden, helping to pass on wealth to the next generation. But be advised: Buying life insurance could increase your tax liability if your policy is not set up correctly.
Here’s what we'll cover in this post:
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Common Mistakes with Life Insurance for Estate PlanningOftentimes, our potential clients come to us with old policies that were not set up to maximize tax advantages. In other words, their life insurance policy will not protect their assets from estate or inheritance taxes.
Creating the wrong type of trust, or purchasing your policy before the trust is established, will negate your ability to avoid or reduce estate taxes.While this scenario is unfortunate, its important to understand that most life insurance agents rarely meet clients who need life insurance for estate protection. In this article we'll explain some of the most common estate planning mistakes we've seen and tell you how to avoid them.
1. Outliving Your Life Insurance
The most common mistake is purchasing a policy that isn't permanent. This is usually the result of buying term insurance to save money. Term life insurance is designed to be temporary, so most people will outlive their coverage. You'll also want to avoid buying a policy that's unaffordable, or you'll be forced to let it lapse.
Guaranteed Universal Life (“GUL”) insurance is the best compromise. It works just like term insurance, but it allows you to lock in your rates and coverage for an extended period of time. Instead of 10 or 20 years, most GUL policies offer guaranteed rates until the age of 90, 95, 100, 105, 110, 120, or 121.
Depending on your lifetime expectancy, most estate attorneys will recommend extending life insurance coverage until age 100 or later. You do not want to risk outliving your policy. Guaranteed universal life insurance policies are also a lot more affordable than traditional whole life insurance.
2. Buying a Permanent “Cash Value” Policy
“Cash value” policies such as whole life, variable life, and traditional universal life combine life insurance with investment vehicles. These policies are relatively expensive and usually charge maintenance fees. Even in a great market, it can take years to accumulate a sizable cash value.
Remember, the “cash value” is only difference between the amount you pay each month, and the cost of your life insurance. Unless you're vastly over-funding your policy, you shouldn't expect to see much growth. Many people become frustrated and cancel these policies when they don’t reach their investment goals.
In reality, your policy accumulate cash to help pay your premiums when you’re older. If the cash is depleted, you’ll have to pay higher premiums to keep your insurance. Its also important to note that, your policy isn't guaranteed. Your insurance company can increase the cost of your coverage you get older.
With a GUL policy, your rates and coverage are guaranteed not to change. The other caveat with traditional non-guaranteed universal life insurance is that the insurer retains the “cash value” after you die. They only pay the policy's death benefit, the cash in your policy is not refunded.
You’ve probably heard the adage, “buy term and invest the rest." While this makes sense for most people, if your goal is lifetime affordable coverage, we’ll amend this to “buy GUL and invest the rest.” You'll have more control of your savings and a much better chance of reaching your financial goals.
3. Being the Owner of your Life Insurance Policy
If your net worth exceeds the exemption when you pass away, being listed as the owner of your policy will create an additional tax liability. The IRS will view your life insurance policy as an asset, subjecting the death benefit to estate taxes when you pass away.
In order to avoid this potential disaster, an irrevocable trust must own your life insurance policy. If an irrevocable trust is listed as the owner of your life insurance policy, the policy is not considered to be part of your estate because it’s not in your control. For the most part, the IRS says, “if you control it, we can tax it”.
Some states also levy their own estate an inheritance taxes that could be assessed against your assets when you pass away. Tax laws vary by state and do change, so check with your tax professional for current tax codes. We can work with them to ensure your policy and trusts are worded correctly.
4. Establishing the Wrong Type of Trust
An alarming amount of applicants contact us to buy life insurance for an estate that's already been established with a revocable trust. If you're purchasing life insurance for estate planning, your assets must be held by an irrevocable trust. The irrevocable trust will also need to pay for your life insurance policy.
A revocable trust can be changed or canceled making the proceeds of your life insurance policy taxable in most instances. The IRS considers a policy that is owned by a revocable trust the same as a policy that is owned by the individual, making the proceeds of the life insurance part of an estate, and therefore, taxable.
To avoid this scenario, you will need to take advantage of the annual gift exclusion of $17,000 per individual (for 2023). Every year, this amount can be gifted to your irrevocable life insurance trust to finance your policy's premiums. This prevents you from ever having control of the policy in the eyes of the IRS.
5. Waiting Too Long to Transfer Your Life Insurance To An Irrevocable Trust
If your trust is owned by a revocable trust, you have the ability to transfer ownership of the trust to an irrevocable trust for tax advantages. However, the IRS is wise to this strategy, and has established a 3-year waiting period for changing ownership between trusts.
If your life insurance policy is owned by a revocable trust and your estate is worth more than $6 million, contact your tax professional about making this change. Often times this technicality is overlooked until it’s too late, resulting in the loss of hundreds of thousands of dollars to estate tax.
Do not wait until you are sick or ill to transfer the ownership of your life insurance, do it now while you’re sound of mind and health.
6. Naming an Incorrect Beneficiary
Most policy owners will list their spouse or an immediate family member as the beneficiary of their life insurance. With life insurance for estate protection, you must list your irrevocable trust as your policy's primary beneficiary. This prevents the policy from being considered as an asset in the eyes of the IRS.
7. Naming Yourself as the Trustee of your Irrevocable Trust
When you establish a trust you must list a trustee to oversee it. You cannot list yourself as the trustee of your own irrevocable trust. Our clients often list a family member as the trustee; however, it’s common to assign a trust attorney or corporate trust professional as your beneficiary.
When you die, your irrevocable trust collects the tax-free payout from your life insurance policy. Your trustee will then use these funds to pay any estate taxes owed, keeping the life insurance benefit separate from your estate. This will prevent your loved ones from owing money on the assets you leave them.
If your heirs do not have money to settle the estate taxes, they'll be forced to sell the assets you want them to enjoy. Oftentimes this results in estate sales where valuable items are liquidated to raise money quickly. The IRS must be paid within 9 months of your passing to avoid penalties.
JRC specializes with life insurance only, and we represent 63 top-rated providers. Our agents specialize with pre-qualification underwriting, allowing them to match each client with the best option available. After a 10-minute risk assessment interview, we’ll be able to provide accurate quotes.
Our mission is to match our clients with highly rated life insurance coverage from companies providing the best value. Each company set's their own rates, and shopping the market could save you thousands of dollars each year. We also specialize with clients that are in less than perfect health.
JRC shops the market, working as a no-cost broker on behalf of our clients. We’ll narrow the list down to your best options and provide professional consultation through the approval process. Our experts will make sure your life insurance is set up correctly…and you won’t be overpaying for your coverage.
Call us today at 855-247-9555 to speak with an expert. Or, you can use our life insurance calculator below to instantly compare your options. After entering some basic information, you'll see actual rates based your age and gender.
Managing Partner and Co-founder
Cliff is a licensed life insurance agent and one of the owners of JRC Insurance Group. He has helped thousands of families of businesses with their life insurance needs since 2012 and specializes with applicants who are less than perfect health. In his spare time he enjoys spending time with family, traveling, and the great outdoors.