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How to Boost Insurance Tax Benefits

Last update on: Oct 17 2017

Insurance products can be great tax shelters. Annuities and cash value life insurance have tax breaks sanctioned by Congress. But a price of the benefits is that there are a number of tax traps. It is easy to fall into one of these traps, and the result can be expensive. Even worse, an entire estate or investment plan can be defeated by one slip. Here are the most common insurance tax traps and how to avoid them.

  • Paying insurance to your estate. Most of you know about this. If you or your estate is beneficiary of a life policy, then the entire value of the benefits is included in your estate. Instead, have another person or an irrevocable life insurance trust be the owner and beneficiary of the policy. That way, all the benefits you paid for avoid income and estate taxes. To avoid the taxes, you cannot have any “incidents of ownership” over the policy, such as the right to change the beneficiary or take loans.
  • Splitting ownership and beneficiary. Suppose your spouse owns the life insurance policy, and your children are beneficiaries. You give your spouse cash each year to pay the premiums. The insurance benefits avoid estate taxes. But your spouse might be treated as making a gift to the children equal to the benefits, because she could have named herself beneficiary but chose to name the kids. The IRS calls that a taxable gift. If your kids are too young to own the policy or you don’t trust them to pay the premiums, put the policy in a trust.
  • Requiring the trustee to buy life insurance. To avoid the two previous mistakes, you set up an irrevocable life insurance trust. One of the trust provisions requires the trustee to use your annual gifts to buy life insurance and to use insurance benefits to pay your estate taxes. You’ve stumbled into another trap. Insurance benefits used to pay an estate’s obligations are included in the estate. Instead, the trust needs to give the trustee discretion to lend money to the estate or to buy assets from it. The estate then would use the cash to pay taxes or debts. Be sure your irrevocable life insurance trust is drafted by an experienced estate planning attorney. It is well worth the expense.
  • Borrowing trap #1. Most cash value life insurance policies allow you to borrow from the cash value, and usually the loan is income tax free. Suppose your basis (the amount you’ve paid in premiums) is $150,000. Your cash value is $250,000. So you borrow $200,000. Then you give the policy to your kids to get it out of your estate.  But you now have $50,000 of ordinary income to report, because you took loans that exceeded your tax basis. In addition, you made a $50,000 taxable gift to your children. There’s a third unpleasant surprise to this trap. On your death, all the insurance benefits are taxable because your loans exceeded the tax basis. The lesson here is that if you want to take a policy loan that exceeds your tax basis in the policy, get some good tax advice first.
  • Borrowing trap #2. Some insureds want to walk away from a policy they no longer need. In insurance lingo, they let it lapse by no longer paying premiums. That’s dangerous if you borrowed from the cash value. When you surrender the policy or let it lapse, the outstanding loans become taxable income. Pay off your cash value loans before letting the policy lapse. You’ll get the money back when the cash value is distributed to you after the lapse. An even better solution would be to continue paying the minimum premiums needed to keep the policy in force.
  • The policy walk away. Suppose you don’t have loans against the cash value and no longer need the policy. You could stop paying premiums and let dividends on the existing cash value pay future premiums. Many policies have a “vanishing premium” feature under which the cash value grows large enough after a period of years to pay future premiums and even to buy extra coverage.Check the rate of return on the cash value before you stop paying premiums. Most cash value accounts have a return of 6% to 8% these days. That grows tax deferred in the account. If you would have invested the premiums in bonds or lower-yielding investments, it makes sense to continue paying the premiums at least until retirement. Down the road, you can begin taking tax-free loans from the account to pay living expenses. Also, by continuing to pay the premiums your death benefit probably will increase. As long as your total loans don’t exceed your tax basis in the policy or cause the policy to lapse, you and your family could be better off with continued investments in the policy.
  • The partial charitable gift. A gift to charity can be a good use of a life insurance policy you no longer need. You’ll get a tax deduction equal to the lesser of the premiums paid in the past and the value of the policy. If you pay future premiums, they’ll be deductible when paid. The charity eventually will get a gift that far exceeds what the policy cost you. But be sure there are no loans outstanding when you make the gift. More importantly, be sure you give the policy completely. Don’t reserve rights such as changing the beneficiary or taking loans against the cash value.



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