Is Your Insurance Hurting You Instead of Helping You?

If you’re not careful to buy the right kind of insurance, keep it in the right place and pay for it in the right way, your good intentions could end up working against you.

(Image credit: Shapecharge Photography (Shapecharge Photography (Photographer) - [None])

Life insurance is probably the most underappreciated and mis-sold element in financial planning, but with proper integration, it can be an almost indispensable vehicle for wealth transfer.

Many people first consider buying life insurance when they purchase a home, get married and/or start a family. Taking on a substantial amount of long-term debt reframes your perspective on monthly expenses as your bills are now no longer one-offs but recurring every month for the next 30 years. Additionally, when you get married or have your first child you realize that income-replacement measures provide peace of mind for everyone involved. And for high-earning professionals, business owners and families of multi-generational wealth, life insurance can play an important role in income tax planning and estate planning as well. But for life insurance to help you accomplish your goals, there are many aspects of coverage that should be thoughtfully and carefully integrated into your overall financial plan.

I’ve helped many individuals and families place, revise, structure and manage distributions from the vast array of life insurance products in the marketplace, and while the majority feel that their existing coverage is adequate and appropriate, what I’ve frequently found is the insurance they have is actually working against their intentions.

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First, a quick primer on the types of insurance and how they work:

Term life insurance: A policy that provides a set death benefit, where coverage is provided for a specific amount of time, generally 10, 20 or 30 years.

Permanent life insurance: A policy that provides coverage for your entire life. Whole life is an example of permanent life insurance whose premiums remain stable and accumulate cash value over time.

Here are three critical insurance pitfalls that can cause more harm than good for policyholders and their beneficiaries.

1. The type of insurance that you have is no longer appropriate.

Consider an individual who got married, bought a house, and wanted life insurance to protect his spouse and their family home from a future loss of earnings should anything happen to him. We find many people who purchase life insurance early in their lives “set it and forget it” and fail to re-evaluate their coverage later when their financial situation and outlook change.

The term insurance you bought when you were younger and healthier may be a great conversion option because your health has declined. Most term policies can be converted to a permanent policy, such as whole, within a certain time frame and without an additional medical examination for an increase in the monthly premium. This can be an appealing option if you want to keep your coverage and lock in a rate. Conversely, let’s say the forgotten policy was a permanent policy with a huge cash value supporting a large death benefit – if ownership was inside the taxable estate, the beneficiaries would not get the full benefit, because you would now be in a taxable situation (over the estate tax exemption), which you may not have been when you bought the policy.

Determining which insurance solution would be most appropriate depends on the family’s goals and the other components of their financial life.

Key takeaway for consumers: Look at your policies every couple of years and review whether they are addressing your current goals in light of any changes in your life.

2. Ownership of the policy doesn’t align with your estate goals.

We have run into situations where a client’s whole life or universal policy has a sizable cash value and is owned inside their taxable estate, instead of in trust. Even if the policy is term, and has no cash value, the death benefit may be free from income taxes for the beneficiaries, but when a policy is owned inside the estate, the benefits will be subject to estate taxes.

When most people buy a life insurance policy, they are not thinking about their future taxable estate. They also make the mistake of assuming life insurance is estate tax free. An individual’s taxable assets in their estate can include deferred compensation, stock options, IRAs, retirement plans, pensions, 401(k)s and profit sharing, investments, real estate, cash, jewelry and even works of art. So, exceeding the federal estate tax exemption ($11.4 million for individuals in 2019, $22.8 million for married couples) may be more likely than you think when you add in a life insurance death benefit, which can easily exceed $5, $10 or $20 million. In addition, keep in mind that many states have their own estate taxes, and their exemption limits can be far lower than the federal limits.

Key takeaways for consumers: In some cases, insurance coverage may be more beneficial when owned in trust, which can move the policy outside of the grantor’s estate and protect death benefits from estate taxes. There are other estate tax solutions as well, such as 1035 exchanges, annual gifting to the beneficiary or gifting to a trust, provided you get the sequencing correct and that you live three years after the gift. If you are in a taxable estate situation and own life insurance, realize there may be tax-advantaged insurance solutions available to you, but periodic policy evaluation is necessary, and time is usually of the essence.

3. Insurance is owned in trust, but with poor administration.

If your life insurance policy is owned in trust, the trustee is required to perform various administrative tasks, such as setting up a bank account to pay premiums and sending monthly statements and other communications to the beneficiaries. One of the most common lapses by trustees is failing to provide Crummey notices to beneficiaries when a gift is made to the trust. Crummey notices provide detailed (and timely) written instructions on how beneficiaries can exercise their withdrawal rights to the money, even if it was deposited for the purpose of paying insurance premiums. Crummey notices qualify the funds as a present interest gift, which beneficiaries can access immediately with no strings attached. Even though the beneficiaries are unlikely to withdraw such funds, the notice must go out letting them know that they could. Oftentimes, simply sending the notice is sufficient and operates under negative consent, meaning no action is required from the beneficiary, but failure to do so when gifts are made qualify them as future interest gifts, which are considered part of grantor’s estate, and could undermine the entire purpose of the trust.

Key takeaways for consumers: It’s vital to work closely with your attorney when creating your trust to ensure it supports your intentions and to name a professional and knowledgeable trustee to administer it. A trustee may be on the ball for the first few years of the trust, but if their attentiveness falls off, or if a trustee is replaced and the new trustee is not aware of their responsibilities, the trust may unintentionally run afoul of IRS regulations. And it’s worth noting that as time progresses, the chances of the grantor dying increases, and the IRS will look at the most recent year when scrutinizing your estate.

This is just the tip of the iceberg when it comes to unforeseen consequences of owning the wrong policy or owning an appropriate policy but paying for it the wrong way. Just like any other aspect of your financial life, careful integration of insurance into your planning strategy and attentive management thereafter is the only way to maximize your benefits.

This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.

Matthew Helfrich, CFP
Partner and President, Waldron Private Wealth

Matt Helfrich is President of Waldron Private Wealth (opens in new tab), a boutique wealth management firm located just outside Pittsburgh, Pa. He leads Waldron's strategic vision, brand and value proposition and overall culture of the firm. Since 2002, Helfrich has served in a number of roles including: Chief Investment Strategist and Chief Investment Officer, where he was instrumental in creating and refining Waldron's investment discipline.