Families commonly take out life insurance policies to ensure their spouse and children receive the insurance proceeds in the event of their death. Although it may seem straightforward, there are common pitfalls of buying life insurance that could be costly in the future.
Think of life insurance as a triangle with three relevant parties involved: the owner, the insured, and the beneficiary. Individuals in these three roles, whether it be a personal, business or estate planning policy, may subject the policy owner to an unwelcome tax bill by way of the proceeds being deemed a “gift” to the beneficiary. Unfavorable tax consequences come into play when there are three different individuals to a transaction, when there should actually be only two. Always remember that two points on the life insurance triangle should be the same person. The policy owner can also be the insured or the beneficiary, but the insured can never be the beneficiary. To avoid falling into the tax trap, make the beneficiary and the owner the same person.
Setting up an Irrevocable Life Insurance Trust (ILIT) could be favorable to avoid estate tax. In this instance, you would name the trust as both the owner and beneficiary of the policy. The trustee of the ILIT then manages the proceeds in accordance with the trust document for the benefit of the trust beneficiaries, who would be the children you would have otherwise named as the beneficiaries on the policy.
It is always best to consult your own tax, legal and accounting advisors before engaging in any transaction.
Contact us to learn more about your life insurance options and how to avoid common mistakes.