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Three Common Life Insurance Tax Pitfalls to Avoid

May 16, 2022

Life insurance is a staple of many financial plans for many reasons - and when structured properly, life insurance possess a number of unique favorable tax characteristics. Policyholders can take distributions from the policy cash value (up to basis), as well as borrow against the policy cash value, generally without income tax. The death benefit paid to the policy beneficiaries is also generally income tax free. However, here are three potential tax traps to be aware of when incorporating life insurance into your financial plan:

  1. Unintentional creation of a modified endowment contract by overfunding your policy on the front end. Many people who purchase a life insurance policy fund it with the minimum premium (or something close to it) and continue to make premium payments over the duration of the policy. However, some may overfund their policy at the front end – motivated by lower monthly premium payments, the potential for faster accumulating cash value, or a combination of both. But policyholders should beware that overfunding a policy at the start can potentially trigger modified endowment contract (MEC) status, which can compromise some of the tax advantages of the policy. By creating a MEC, you may no longer be able to access policy cash value free of income tax, thereby losing one of the big tax perks of a permanent life insurance policy. Furthermore, once you’ve created an MEC, it generally cannot be reversed. If you are using your life insurance policy purely as a legacy planning tool (death benefit driven plan), this may be immaterial. Also, in either case, your beneficiaries can still receive the policy’s death proceeds income tax free. Your financial advisor will be able to help you determine the most appropriate policy structure and funding to best achieve your particular planning objectives.
  1. Ensure your policy’s death benefit remains income tax free to your beneficiaries. Besides tax favored access to the cash value of your policy, a second perk is the income tax free death benefit paid to your policy beneficiaries. However, under certain circumstances, assigning ownership of your policy could compromise this benefit. Any time you’re contemplating changing ownership of a policy, work with your financial advisor to make sure you aren’t jeopardizing the income tax advantaged status of the death proceeds by triggering a “transfer for valuable consideration” (which does not meet one of the limited exceptions). Note, a transfer that is purely gratuitous in nature (e.g., gift) does not constitute a transfer for valuable consideration. What’s tricky is that not all transfers for value are obvious, so be sure to check with a qualified advisor.
  1. Avoid the life insurance “tax triangle.” In life insurance planning, the so called “tax triangle” is another potential concern. The triangle occurs when there are three different parties named as policy insured, owner and beneficiary. If your policy ownership and beneficiary designations are out of alignment, you could fall into this tax trap – subjecting the death proceeds to potential income tax or gift tax. Unfortunately, this happens more often than you might expect. This can commonly occur where one spouse (insured) purchases a policy for their partner (policy owner) who then designates their children as the policy beneficiaries, thereby subjecting the proceeds to potential gift tax upon the insured’s death (gift from policy owner to policy beneficiaries). In the business or employment context, this can occur where a business owns a policy on the life of an employee (insured) and names another party as the policy beneficiary (e.g. employee’s spouse, children), thereby subjecting the death benefit to income tax (compensation paid to beneficiaries).

Individuals purchase life insurance with the understanding that the policy and the proceeds will be taxed favorably. However, mistakes can inadvertently be made which can cause unexpected tax consequences.

With good planning, both the policy owner and beneficiary can be confident the policy will retain favorable tax treatment. It’s also important to reassess life insurance coverage from time to time as personal circumstances change and needs evolve. Not sure if your coverage is appropriate for your current situation, or whether your policy has any tax or other concerns that need to be addressed? Our wealth advisors are available to evaluate your coverage, and work with you on optimizing your life insurance structure within your broader financial plan. Contact us today for a consultation.

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This article is for general information purposes only and is not intended to provide legal, tax, accounting or financial advice. The information in this article, and any opinions expressed therein, do not constitute a recommendation or an offer to buy or sell any security or financial instrument. Viewers should consult with their financial and/or legal professionals before making any financial decisions.