1. Telling Clients Life Insurance Is “Tax Free”
Life insurance is often free of income tax, but it is likewise usually subject to estate tax unless it is planned carefully.
2. Giving The Client “Incidents Of Ownership” In The Policy
If the insured has incidents of ownership, then the death benefit will be included in the insured’s taxable estate. Other than outright ownership, an insured can have incidents of ownership if the insured has the right to change the beneficiary, borrow against the policy, use the policy as collateral, cancel the policy, retain a reversionary interest of greater than five percent, or veto any of the above powers.
3. Having The Spouse Own The Policy
If the spouse owns the policy, the death benefit will be included in the spouse’s estate. If the spouse has any incidents of ownership, as noted in Mistake #2, the same applies.
4. Having The Children Own The Policy
Having the children own the policy avoids inclusion in the estate of the insured, but it moves inclusion to the estate(s) of the children. It also creates difficulty in determining who should pay the premiums. When one sibling pays and the others benefit from that, the payor made a gift to the other siblings that may impact the payor’s estate planning. Also, if one sibling pays and one or more do not, do the non-payors still receive the death benefits?
This method can also create problems with the exercise of ownership. Who can change the beneficiaries? Who can cancel the policy? Who can borrow against it or use it as collateral? With multiple owners, the answers to these questions are usually not what the client wants to hear.
5. Transferring An Existing Life Insurance Policy To A Trust Without Consideration Of The Consequences
If the insured dies within three years of transfer of an existing policy to a trust, the death benefits of the policy will still be included in the insured’s estate. There are ways around this, including the option of having the trust purchase the insurance from the insured, or buying short-term insurance for the three year window.
6. Applying For The Policy With The Plan To Have A Life Insurance Trust
Later As with Mistake #5, if the insured applies for the policy, then the issuance of the policy in the name of the trust may be deemed a transfer of an existing policy. In many instances, the insured can begin a preliminary process, including a medical exam, without a full-blown application and avoid this problem.
7. Not Considering In Advance Whether Premiums Will Be Annual Exclusion
Gifts Or Otherwise Every time the person who pays the premium for life insurance is not the only person who will receive a death benefit, the payor is making a gift to the beneficiaries. Even if the payment is made by a trust, if someone gifted money to the trust in order to make that payment, there is a gift to the beneficiaries. Therefore, the team of advisors must give careful consideration to whether that gift will qualify for the annual exclusion, the lifetime gifting exemption, or will otherwise be taxable.
8. Having The Insured Pay The Premium Directly Where The Insurance is Owned By A Trust
Although some practitioners are of the belief that the IRS isn’t currently concerned with this, the law is still clear that if the insured pays the premium directly, this is a non-present interest gift to the beneficiaries. That’s important because only gifts of a present interest qualify for the annual exclusion or “under the radar” treatment. If a gift is not of a present interest, it is still a taxable gift, and must either apply to the lifetime exclusion or be subject to gift tax.
9. Not Warning The Insured And The Trustee Of The Need For Crummey Letters
Even if the insured makes a gift to the trust and then the trust pays the premium, the insured made a non-present interest gift to the beneficiaries unless the beneficiaries had a chance to take the money directly. The usual practice is to gift the funds to the trust, then write letters to the beneficiary informing them of their right to take the funds. When they don’t take the funds, generally after 30 days, then the trustee can use the funds to pay the premium. The letters to the beneficiaries are called “Crummey letters” because they were approved in a court case involving an insured named Crummey.
10. Not Working With A Qualified Team Of Advisors
As the previous nine mistakes indicate, life insurance and trusts are complex matters involving income tax, estate tax, gift tax, and general financial advice. The client is best served if the advisor brings in a team or works with the client’s existing team to provide income tax advice and estate planning advice to fill out the insurance and financial planning advice the client needs.