Financial planning involves a big picture examination of one’s entire financial picture to devise strategies to achieve long and short term financial goals1. Unfortunately, financial planning is often viewed simply as a synonym for investments, but it is so much more. A comprehensive cross-disciplinary approach involves considering investing, taxes, retirement issues, estate issues and insurance issues among others2.
Life insurance is considered a valuable tool for financial, retirement, business and estate planning purposes. Its potentially favorable income tax treatment, the death benefit and internal cash value are major reasons it is a popular problem-solving tool.
Over the years, the Family Wealth Decisions Group has observed many life insurance decisions which could have turned out better…and probably should have turned out better. We are limiting this discussion to only five in areas we consider to be foundational.
Mistake #1: Not considering owning life insurance.
Not even considering life insurance as a potential solution may be a significant planning mistake. Life is unpredictable and unanticipated events such as a premature death can jeopardize the surviving family’s ability to meet their family goals such a college education for children or grandchildren, and funding lifestyle and/or retirement for a surviving spouse. A premature death of a family income provider may even jeopardize the surviving family’s ability merely to maintain themselves. Life insurance can provide the cash to maintain the pre-death lifestyle and satisfy debt accumulated during life such as mortgage loans, student loans and consumer debt.
The numbers are concerning. Notwithstanding the big picture value of life insurance discussed above: the number one reason for purchasing life insurance is to cover burial and funeral expenses; 48% of Americans are uninsured; and 30% would suffer a hardship after only one month after an income-provider’s death3. One of the rationalizations for eschewing life insurance that the Family Wealth Decisions Group has heard is the belief that they can wait “until they need it” to buy it. I am not sure I know what that means. Life insurance is most likely unavailable to insure those who are terminally ill, and it is definitely not available to insure those who have died.
Mistake #2: Not considering anything besides term insurance.
Term insurance is temporary insurance for a term of years. After the term of years expires, if not renewed, the death benefit ceases to exist. Due to its temporary nature, term insurance generally has a lower premium than a permanent “cash value” policy with the same death benefit. It does not build equity over time as generally there are no cash values4.
To be sure, term coverage has its place in providing significant temporary death benefit, possibly for decades, at a low manageable cost. However, emphasis is on the word temporary. If death benefit for your entire life is desired, possibly to age 100 or beyond, if you do not want to risk outliving the policy term, term insurance may not be the answer. You may need to consider the purchase of a permanent life insurance policy, or you may need to consider whether and how you might convert an already issued term policy into a permanent policy.
Mistake #3: Not understanding policy title and structure options.
Although term insurance is not necessarily simple with the longevity and rider choices available, the universe of permanent life insurance can be more complex. This universe can include: current assumption universal life insurance, indexed universal life insurance, variable universal life insurance, guaranteed universal life insurance and whole life insurance. Understanding the differences among these policy structures and how each of these may or may not apply in your case can be a daunting task – but it is a task that should be addressed to increase your ability to make a good decision.
For example, universal life insurance may also be referred to as flexible premium adjustable life insurance. You can change the premium amount or even skip a premium payment assuming there is sufficient cash in the policy to make up the shortage. You may even be able to decrease the policy death benefit5. If these and other structural options are not well understood, the potential value of this flexibility may not be recognized where it could be helpful.
Aside from the structure of the policy is the question of who should own the insurance contract. The contract owner controls the policy during the insured’s lifetime. The owner has the power to surrender, sell, gift or change the beneficiary as well as make changes in the policy structure6.
Often, the insured is the policy owner as well. However, sometimes this is not the case. Sometimes a trust may be the policyowner; sometimes a business; sometimes another person. There may be gift tax ramifications where the insured, policyowner and beneficiary are three different people7 and there may be estate tax consequences where an insurance policy is transferred within three years of death (IRC §2035(d)).
Mistake #4: Not understanding life insurance income taxation.
The utility of the life insurance tool would decrease immensely if favorable income tax treatment were not available. However, the rules governing the availability and inadvertent forfeiture of the tax advantages can be incredibly complex.
The Transfer for Value rule regarding the taxation of a life insurance death benefit is a classic example of the complexity of some of the life insurance tax rules. This rule essentially involves a discussion of exceptions to an exception to an exception of a general rule. Violation of the transfer for value rule may arise insidiously as what constitutes a transfer for value sometimes may be difficult to spot.
The general rule referred to is that gross income includes all income from whatever source derived (IRC §61). A life insurance exception is provided in IRC §101(a)(1) where gross income does not include amounts received under a life insurance contract paid by reason of the death of the insured. This is why most of us understand that life insurance death benefits are generally income tax free.
An exception to this exception to the general rule is that the transfer of an interest in a life insurance contract for valuable consideration may result in the inclusion in gross income of policy proceeds otherwise paid on account of the death of the insured (IRC 101(c)). Several exceptions to this exception exist permitting certain transfers for value without the requirement to include any policy proceeds in gross income (IRC §101(a)(2)).
Taxation complexity continues when considering the Modified Endowment Contract (MEC) and taxation of the internal policy values. Generally, the investment in a life insurance contract (the premiums, for example) may be the first funds withdrawn and may be withdrawn tax-free, after which excess distributions (gains in the contract) may be taxable (IRC §72(e)(5)). However, funding a life insurance policy too fast may result in a MEC which turns this potential tax advantage on its ear making withdrawals and loans potentially taxable before the investment in the contract can be withdrawn without tax (§7702A).
Mistake #5: Not coordinating insurance decisions with other financial decisions.
Lack of planning coordination is an error we see with nearly every type of financial decision and planning. Often, decisions about whether to purchase life insurance, how much to buy and what type to buy are made in a silo – in isolation of other financial decisions. The financial decisions you make may be made with different advisors at different points in time for different purposes. A lack of planning coordination among these decisions may cause gaps through which wealth may be lost or which may cause goals not to be fully met.
You may intend to leave wealth to your family through life insurance, but will the policy outlive you? Have you considered the fact that inflation may reduce the purchasing power of the death benefit over time? Have you coordinated your life insurance beneficiary designations with those in your will or trust or retirement accounts? Do you need any creditor protection for the insurance proceeds in the event the beneficiaries make poor financial, business or marital decisions? Does your big picture post-mortem asset flow meet with your satisfaction? One of the areas of inquiry in periodic reviews should be the coordination of your life insurance policies with the rest of your financial decisions such as asset titling and beneficiary designations.
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Clearly, dealing with life insurance may be far more complicated than originally thought. The decision about whether to own insurance, who should be the titled owner, the type of policy to own and an understanding of the tax and planning ramifications of life insurance are questions where experienced professionals can help avoid undesirable consequences.
We consider the five mistakes addressed above to be foundational in dealing with life insurance. However, we have seen many others – some big and some small. Why do these mistakes occur? Sometimes decisions may be made emotionally, compulsively or rashly. Sometimes decisions may be made in the absence of good information or based on misinformation. Sometimes decisions may be made carelessly without consideration of the potential consequences in the mistaken belief that the decisions are not really important.
Good life insurance decisions should be made not only considering their immediate consequences, but also those that may derive from them. These decisions should not made in a vacuum, isolated from all other planning decisions, but rather should be made in coordination with them. This is also where an experienced credentialed advisor can be of assistance and value.
Whether you need to buy life insurance now or merely review your life insurance planning, a conversation with an advisor can be beneficial. Often mistakes, once discovered, can be reversed, repaired or overcome. Sometimes they cannot be corrected or ameliorated. This is why we offer a complimentary consultation to discuss these and other financial decisions you may need to make. Contact us to arrange your consultation.
1. https://www.cfp.net/why-cfp-certification/career-guide/what-is-financial-planning
2. https://smartasset.com/financial-advisor/financial-planning-explained
3. https://choicemutual.com/blog/life-insurance-statistics/
4. https://www.securian.com/insights-tools/articles/term-life-vs-permanent-life.html
5. https://www.progressive.com/answers/adjustable-life-insurance/
6. https://www.actec.org/resource-center/video/understanding-life-insurance-policy-ownership/
7. https://belongingwealth.com/goodman-triangle-the-unholy-trinity-of-life-insurance/
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