Choosing a life insurance policy is a major decision for many clients. The decision that they make will ultimately affect their future and the future of their loved ones. As financial advisors it is important to keep your clients informed and always point them in a clear direction.
We've compiled a list of the top life insurance mistakes and how to avoid them. Share them with your clients to ensure they don't make these costly mistakes.
Life Insurance Mistakes Your Clients Should Avoid
- Not Knowing What They're Buying
A lack of knowledge and education can be extremely costly for clients. Life insurance is not one-size-fits-all. Clients need a high degree of comfort with the insurance carrier, the agent and the products being considered before purchasing anything. Advise your clients to do the research and take the time to fully understand all of the benefits and risks of each option you propose. Keeping an open line of communication and a level of understanding is crucial in building a strong relationship with your clients.
- Three People on a Policy
The beneficiary of a properly structured life insurance policy will generally receive the death benefit income and gift tax-free. However, when three different parties are designated as the owner, the insured and the beneficiary of a life insurance policy, policy proceeds are subject to gift taxation. Should the insured person die under those circumstances, the proceeds are considered to be a gift from the owner to the beneficiary. Make sure you advise your clients that either the insured and owner should be the same individual; or the owner and beneficiary should be identical.
- The Business is the Owner
Similarly to above, issues can arise when the business is the owner. When business owners name themselves as the insured, use the business to own the policy and name a spouse, child, or another business owner as the policy beneficiary there can be negative tax consequences. By ensuring that your clients properly structure the policy as well as the beneficiary designation, you can eliminate this potential headache.
- Failure to Name a Successor Owner
A big mistake people tend to make is not recognizing that life insurance is an asset. If the owner and insured on a life insurance policy are two different people and the owner dies first, the policy ownership has to pass to a successor owner. If the policy owner did not name a successor owner, the policy will be subject to probate. Probate can cause the policy to be subject to creditors’ claims and unnecessary costs. It can also cause ownership of the policy to pass to an unintended owner or to be divided among multiple owners. Advise your clients to make sure that if the insured and owner are different individuals, either name at least one successor owner or have an entity such as a trust own the policy.
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- Estate as Beneficiary
If the estate becomes the beneficiary unintentionally the policy proceeds may be subject to probate, creditor claims and estate or inheritance taxes. Make sure that your clients name both primary and secondary beneficiaries to ensure that the estate does not unintentionally become the beneficiary.
- Policy is Subject to Estate Tax
If an individual is the owner of their policy, all of the death proceeds are included in their estate. For most individuals, this will not be a problem; however, if the estate is large, unnecessary estate taxes may occur. Typically, when an individual discovers that ownership of a policy creates an estate tax problem, they transfers ownership to another individual or trust. This is not the most sound solution and should be advised against. The Internal Revenue Code contains a rule that provides that if an insured owns a policy on their life and gives the policy to another person, trust, or entity and then dies within three years of the transfer, the policy proceeds will be included in the estate of the insured and subject to estate taxation. While there are a number of complex ways to structure a transfer to avoid the three-year estate inclusion, one simple solution is to purchase a separate insurance policy for the three-year period during which the policy would be subject to estate tax. Check out this article on the 3 year rule.
Walking through each of these situations with your clients, should they arise, and advising them on the best course of action could save them a lot of time and money down the road. Check back next week when we list 6 more life insurance mistakes that could be detrimental to your clients.
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