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by Brett W. Berg on May 10, 2018 9:00:00 AM

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Three Mistakes in Life Insurance Planning (and How to Avoid Them)

Life insurance policy ownership and structure should be considered just as mindfully as any other part of the client’s estate plan. Here are some of the most common mistakes advisors can make…and how you can avoid them.

Three Mistakes in Life Insurance Planning (and How to Avoid Them) By Brett W. Berg


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Here is how to avoid three common mistakes in life insurance planning.


All too often, advisors take for granted the ownership and structure of their clients’ life insurance policies. As in every other aspect of planning, mistakes can be made and they can be costly. Life insurance professionals and other advisors should carefully coordinate on policy ownership and beneficiary choices when setting up plans and continue to review with their clients to ensure plans are properly updated. This article covers how to avoid making common mistakes in three areas.


Take care in naming beneficiaries. 

Life insurance professionals should take particular care when naming beneficiaries. For example, in many cases, clients purchase life insurance seeking to avoid the time-consuming, expensive and public process of probate. Probate is a post death court process, which involves division of a client’s assets according to a will or, in cases where there is no will, according to state law.


In situations in which the estate is named as beneficiary, the proceeds from the life insurance policy will become part of the probate estate. If the client wanted to avoid probate with respect to their life insurance, naming beneficiaries could have saved much time and expense.


Of course, naming beneficiaries is just the first step; keeping them updated is just as important. Failing to readjust beneficiary information following marriage or divorce or following an update to an estate plan can also lead to problems.


The main point is that incorrect or stale beneficiary information can cause unnecessary mistakes that could have been easily avoided. That’s why it is critical that advisors work closely with their client’s lawyer to ensure that the life insurance beneficiary designations are updated properly and coordinated within the client’s overall financial and estate plan.


Remember to avoid the Transfer for Value Rule. 

Life insurance professionals should take care in helping clients avoid violating the transfer for value rule. While life insurance proceeds are generally income tax-free. When a client transfers a policy for something of value (money, property, etc.), the client may violate the transfer for value rule — subjecting the death-benefit proceeds to income taxation. This clearly would lead to an unwelcome outcome, transforming what should be tax-free death benefits into ordinary taxable income.


The Internal Revenue Codes does list five categories of transfers that will not violate the transfer for value rule. They are transfers to:

(1) the insured

(2) a partner of the insured

(3) a partnership in which the insured is a partner

(4) a corporation in which the insured is an officer or shareholder

(5) any person where the transferee’s basis in the policy is determined in whole or in part by reference to the transferor’s basis (i.e., carryover basis transferees).


So, for example, if ABC Company owns a key person policy on the life of Elliott Employee and transfers the policy to Elliott, then the transfer is to the insured; therefore, the transfer for value rule is not violated in that case.


The rules and exceptions can be very complicated. Again, the solution is to review any decision to transfer a policy with the client’s attorneys and tax advisors before transferring the policy.


Carefully coordinate policy ownership with the overall estate plan. 

When life insurance is owned individually by a client, the proceeds are includible in the client’s estate for federal estate-tax purposes. To avoid a taxable event, life insurance professionals should work with the client’s estate-planning attorney to ensure that the policy is purchased outside the client’s taxable estate.


For example, if the client properly establishes an irrevocable life insurance trust (ILIT), gifts money to the ILIT and the ILIT purchases the life insurance policy, the policy should be outside the estate and not subject to federal income taxes.


Of course, these are only a few examples of mistakes advisors can make and the repercussions for their clients. The important takeaway is that life insurance policy ownership and structure should be considered just as mindfully as any other part of the client’s estate plan. Advisors should carefully review policy ownership, beneficiary and transfer decisions and periodically review them to ensure that the life insurance policy is properly structured to carry out the client’s goals. 

Brett W. Berg serves as Vice President, Advanced Markets, in Prudential’s Individual Life Insurance business. He can be reached at brett.berg@prudential.com.


This article appeared in Advisor Today.