Lang Investment Services Life Insurance

Common Tax Traps Involving Life Insurance

Life insurance delivers cash to beneficiaries when it’s needed most. Plus, if the policy is properly structured, the beneficiaries receive the death proceeds income tax free. By understanding potential tax traps related to life insurance, you can avoid costly mistakes. A few of the most common pitfalls are outlined here.

Three people on a policy

If you gift property to another person, the transfer triggers gift taxes based on the taxable value of the gift. When you transfer ownership of an existing policy to someone other than your spouse, the gift is immediate and generally approximates the cash value. There is an important exception, however. When the owner, the insured, and the beneficiary are three different people, the gift occurs when the insured dies, and the death benefit is treated as a taxable gift from the policy owner to the beneficiary. Under what is known as the Goodman Rule, the gift is no longer based on the policy’s cash value but, rather, on its death benefit.

The solution is to eliminate one party. To avoid potential gift taxes, the owner and the beneficiary or the owner and the insured should be the same person. If the goal is to benefit a third party, an irrevocable life insurance trust should be the owner and beneficiary of the policy.

Three people on a policy in a business situation

This scenario is similar to the previous trap except that, rather than triggering gift taxes, the death benefit is treated as taxable compensation of the employee (or as a dividend of a shareholder). For corporate-owned policies with personal beneficiaries, the business is deemed to have received the death proceeds and then paid them to the employee or shareholder’s family. Thus, the beneficiary owes income taxes on the death benefit as a distribution from the business.

One possible solution is an endorsement split-dollar arrangement. With this kind of plan, the business owns the policy but allows the employee to name a personal beneficiary. While the employee is working, the employer is taxed on the policy’s “economic benefit.” If the policy is properly structured, the death proceeds should be income tax free. Keep in mind that a notice and consent requirement must be met before an employer-owned life insurance contract is issued.

Alternatively, an executive bonus plan can eliminate the tax-on-death problem. The business pays the premiums for a life insurance policy personally owned by the employee. While the employee is working, the payments are treated as additional taxable compensation.

Exchange of a policy encumbered with a loan

Under Section 1035 of the Internal Revenue Code, you can exchange one life insurance contract for another without triggering income taxes. But when an existing loan is extinguished in the exchange, it may cause unwanted tax consequences. Generally, if the loan will be cancelled (discharged) in the course of the exchange, then the amount of the loan is treated as ordinary income up to the amount of the policy’s gain. The first-in, first-out rule does not apply when a withdrawal is made from the cash value to pay off a loan during or shortly before a 1035 exchange transaction.

One solution is to arrange for the new life insurance policy to take over the existing loan. Because you’re in the same economic position before and after the exchange, no gain should result. But keep in mind that the loan may affect the new policy’s performance and possibly shorten or eliminate the guaranteed death benefit.

Alternatively, you may wish to pay off the loan with out-of-pocket dollars before the exchange. One word of caution: a normally tax-free withdrawal of basis to pay off the loan shortly before an exchange is treated by the IRS as a step transaction and can trigger taxes.

Gift of a policy encumbered with a loan

Typically, the gift of life insurance creates no income tax recognition for either the donor or the recipient, although gift taxes may be involved. When a policy is subject to a loan, however, the transfer of the policy relieves the original policy owner of the debt. Because the donor is deemed to have received an economic benefit from transferring the loan obligation to the new policy owner, the transfer is treated as if the policy were sold. If the loan exceeds the policy owner’s basis, the donor will recognize taxable income.

Lapsing a policy encumbered with a loan

One key benefit of permanent insurance is the right to take out a policy loan without having to qualify financially. An insurance company makes a policy loan from its general fund using the policy cash value as collateral. Repayment of the loan principal or the annual interest is optional, and unpaid interest is added to the loan principal. If the borrower fails to repay the loan before the death of the insured, the money is simply withdrawn from the insurance death benefit before it is distributed to the policy beneficiaries.

It’s important to note that life insurance contracts may have an automatic premium loan provision that authorizes the insurance company to lend money to pay the premiums if the policyowner fails to do so. Left unmonitored, an automatic loan provision can result in a lapse of the policy and unexpected taxes.

Taking a withdrawal in the first 15 policy years

Normally, a withdrawal from a policy’s cash value is treated as coming first from cost basis and subsequently from the contract’s gain, resulting in a one-to-one reduction of the death benefit. There is an important exception, however. A withdrawal from a universal life or variable universal life policy within the first 15 policy years will be treated as coming from gain first, if there is any.

To deal with this risk, some insurance companies allow for up to a 10-percent withdrawal with no reduction in the death benefit. If you wish to take more than 10 percent of the policy’s cash value, consider structuring the transaction as a loan. Be sure to weigh the long-term cost of the loan against the potential tax associated with a withdrawal.

Incorrectly structured cross-purchase policies

If it’s not properly structured, life insurance purchased to fund buy-sell plans may have unwanted tax consequences. In a cross-purchase buy-sell arrangement, each business partner owns a policy on the other partners. At the death of a partner, the survivors use the insurance proceeds to buy out the estate of the deceased. Thus, each business partner is both the owner and beneficiary of the policy he or she has taken out on the other. Any other arrangement can fall into the transfer-for-value trap.

If a policy is transferred for money or something of value, the death benefit is no longer fully income tax free. For example, the mutual obligation to purchase a co-owner’s business interest at his death would be considered something of value. The transfer-for-value rule also applies when one partner buys a personal policy on his or her own life and makes his or her partner the policy beneficiary.

Exceptions to the rule include:

  • A transfer of the policy to the insured
  • A transfer of the policy to a partner of the insured or to a member of a limited liability company taxed as a partnership
  • A transfer of the policy to a partnership in which the insured is a full partner
  • A transfer of the policy to a corporation in which the insured is a stockholder, an officer, or both
  • A bona fide gift, such as a transfer of the policy to a spouse or trust of the insured

The simplest solution is to purchase new policies to fund the buy-sell arrangement. If that’s not possible, the business owners should try to qualify under one of the exceptions above. If the business owners are not already partners in some business entity, they may consider creating or investing in a partnership.

Using life insurance instead of a trust
To avoid the cost and complexity of a trust, some parents elect to have their adult children jointly own their life insurance policies. In such cases, the parent’s payment of the premiums directly to the insurance company will not qualify for the annual gift tax exclusion. Although the parent is making an indirect gift to his or her children, the gift tax exclusion is only available if each policy owner has an unrestricted right to access the policy’s cash value. With joint ownership with right of survivorship, neither child can access the cash value without consent of the sibling.

Sometimes, a parent may transfer his or her life insurance policy to one child and ask that all siblings remain as beneficiaries, which is a classic example of the Goodman Rule. At the parent’s death, the child who owns the policy will be deemed to give the policy proceeds to his or her siblings, possibly incurring gift taxes.

If optimizing the annual gift tax exclusion is an important goal, consider a trust to hold the life insurance. Alternatively, you can explore ownership as joint tenants in common. With joint tenants in common registration, each owner has an undivided 50-percent interest in the policy’s cash value. Not all insurance companies offer this kind of registration, however.

This material has been provided for general informational purposes only and does not constitute either tax or legal advice. Although we go to great lengths to make sure our information is accurate and useful, we recommend you consult a tax preparer, professional tax advisor, or lawyer.

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Matthew Lang is a financial advisor located at 236 N Washington St, Monument, CO 80132. He offers securities and advisory services as an Investment Adviser Representative of Commonwealth Financial Network®, Member FINRA/SIPC, a Registered Investment Adviser. He can be reached at 719-481-0887 or at matt@langinvestmentservices.com.

© 2019 Commonwealth Financial Network®

Elder care

Caring for an Aging Parent

Caring for aging parents can be a difficult planning aspect to balance. If you are among the “Sandwich Generation,” you may be trying to support your aging parents as well as your own children. Today, individuals are living longer than before, so it is better to be prepared.

Having the conversation

The first step—and often the most challenging one—is to find out what your parent needs or expects from you. It’s always best to have this conversation before a crisis occurs. Also, keep in mind that your parent may resist discussing the topic at first. He or she has lived a long time without much assistance from you, and the transition to accepting your new role in his or her life may be bumpy. Understanding and respecting your parent’s wishes will go a long way toward smoothing the process. It is also important to understand the difficult conversations for a number of reasons. How will your parent deal with incapacity, the fear of becoming dependent, or the reluctance to burden you with his or her needs?

Gathering information and documents

Create a list of emergency contact numbers, including your parent’s medical providers; religious leader; neighbors; friends; and financial, tax, and legal advisors. You should also gather copies of legal documents, funeral plans, medical records, and medication information. Keep a list of investment, bank, and insurance accounts, in addition to the locations of safe deposit boxes, real estate deeds, and automobile titles. You may find it helpful to upload all of this information to a USB flash drive so that it’s readily available when you need it.

Evaluating your parent’s situation

It may be difficult for you to evaluate your parent’s mental and physical capabilities or to locate community services to support his or her independence. If that’s the case, a geriatric care manager can be indispensable, particularly if you live some distance from your parent. He or she can perform an in-home assessment, determine your parent’s housing needs, and recommend a plan of action. Your parent’s doctor should be able to refer you to a qualified geriatric care manager.

Can your parent remain at home? Just because your parent can no longer care for his or her home doesn’t mean that he or she has to move. In fact, staying in one’s home may offer better support and social networks than moving in with one’s children. If your parent can stay safely alone, you may want to divide up the household chores among family members or hire someone to provide housekeeping, cooking, and personal care. Here are a few other items to consider:

 Find out if Meals on Wheels is available in your area. The organization’s volunteers deliver meals to seniors who can no longer cook for themselves.

  • Look into modifying your parent’s home to help with any physical limitations.
  • Install a security system to summon emergency personnel if necessary.
  • Call the local police department to find out if it offers a program to check on elderly residents. If not, churches often have a volunteer group dedicated to checking in on older parishioners.
  • Post important telephone numbers for contacting you, emergency services, and your parent’s doctor in a prominent location.

As your parent grows older, an assisted living facility or retirement community may be a better solution than living at home. Such residences provide additional benefits, such as transportation, access to medical personnel, and a richer social life.

Another solution is moving mom or dad into your home. This is a big decision, and it may not be the best choice for every family. Ask yourself:

  • Will living together put stress on your relationship with your parent or on your relationship with your family?
  • Can you afford to remodel your home to provide a comfortable and private environment for your parent?
  • Do you have the flexibility to provide transportation as needed?
  • Will other family members step in to help, both financially and physically?
  • Will other family members share the cost of adult day care?

Can your parent continue to drive? If your parent is over age 75, takes medications, or both, his or her ability to drive a car may be impaired. Of course, it’s difficult to know when parents have become a danger to themselves or others. Give your parent’s friends and neighbors your contact information and ask them to make you aware of any changes in his or her driving skills. Or suggest that your parent accompany you for grocery shopping and other errands rather than driving alone. Many communities offer driver’s education courses that teach best practices for seniors (e.g., limiting drive time to daylight hours and good weather conditions, avoiding highway or high-traffic situations).

Keep in mind that this may be a very sensitive topic for your parent. Many seniors view driving as essential to their independence and will resist giving up the car keys. For help approaching the conversation, see AARP’s family discussion guide on senior driving: www.aarp.org/home-garden/transportation/we_need_to_talk.

Financial and legal issues

As we age, we lose mental alertness. Due dates for bills pass, insurance policies lapse, and poor financial decisions may be made. Your elderly parent will likely need your assistance with his or her financial, legal, and medical matters.

Banking. Most banks offer automatic bill-payment services from checking or savings accounts—a convenient option if your parent is Internet savvy. Or your parent can give you responsibility for his or her finances by having bills and financial statements sent to your address. You might also consider a bill-pay service, which receives a copy of invoices and then requests your parent’s bank or financial institution to send checks directly to payees.

Investments and insurance. If day-to-day management of your parent’s finances is too much for you to handle, talk to your financial advisor. He or she can recommend products that provide income on a regular basis, such as managed retirement income portfolios, annuities, or bonds. Your financial advisor can also propose cash-management solutions, which allow your parent’s monthly social security, retirement plan, and annuity payments to be deposited automatically into an account. You can typically access these funds through a debit card, unlimited checkwriting capabilities, and online bill-pay services—everything that a bank checking account offers.

Also review your parent’s existing life and long-term care insurance coverage and make changes if necessary.

Legal concerns. An elder law attorney can help you prepare documents to manage your parent’s health care and financial affairs. In fact, many states provide free legal services to the elderly. Your parent may wish to seek an attorney’s help in the following areas:

  • Appointing a health care representative. Without legal authorization from your parent, medical privacy laws prevent doctors from discussing his or her medical conditions with you. In addition to appointing a health care power of attorney, your parent may want to consider a living will, which provides instructions on how to manage treatment if he or she has a terminal or irreversible condition and cannot communicate.
  • Understanding the process for qualifying for government programs like Medicaid or veterans benefits. Don’t rely on the experiences of family or friends, as their situations may differ from your parent’s.
  • Reviewing and updating estate planning documents, including his or her will, durable power of attorney, and any revocable trusts. Besides the basic estate planning documents, your parent may wish to draft a letter outlining who will receive personal effects like jewelry and family heirlooms.

What about taking care of you?

Although caring for an elderly parent can feel overwhelming at times, you are not alone. Many local and national groups are available to support you in providing the care and services your parent will need. To get started, visit the U.S. Administration on Aging’s Eldercare Locator at www.eldercare.gov, or call 800.677.1116.

At your workplace, talk with a member of the human resources staff to find out if you’re eligible for unpaid leave under the Family and Medical Leave Act. Also ask about the availability of an employee assistance program (EAP). EAPs are intended to help employees deal with personal problems—including concerns about aging parents—that might adversely impact their work performance, health, and well-being.

Finally, seek the help of a financial planner. Besides reviewing whether your parent’s resources are sufficient to pay for care, he or she can help you determine how to balance your own goals with your parent’s needs.

Additional online resources

For further information on caring for an aging parent, you may find these online resources helpful:

 This material has been provided for general informational purposes only and does not constitute either tax or legal advice. Although we go to great lengths to make sure our information is accurate and useful, we recommend you consult a tax preparer, professional tax advisor, or lawyer.

 Matthew Lang is a financial advisor located at 236 N Washington St, Monument, CO 80132. He offers securities and advisory services as an Investment Adviser Representative of Commonwealth Financial Network®, Member FINRA/SIPC, a Registered Investment Adviser. He can be reached at 719-481-0887 or at matt@langinvestmentservices.com.

© 2018 Commonwealth Financial Network®