Mistakes to Avoid If You Have Life Insurance

People need to possess life insurance at different times for survivor income and estate planning purposes. Unfortunately, life insurance can be a complex product, and it’s important to avoid mistakes that can result in unnecessary taxation and disputes.

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The Wrong Beneficiaries

Feature of life insurance is the capability to name beneficiaries and dictate how the death benefit will be distributed. If your spouse or partner predeceases you and no contingent beneficiaries have been named, the death benefit may revert back to your estate. This means the proceeds could be distributed according to the instructions in your written will, or if there is no will according to state intestacy rules. It is important to name depending beneficiaries. After the death of a spouse or a divorce, don’t forget to update your beneficiary elections, including for group policies.

Policy Loans and Lapses

Insurance companies support taking loans against the cash value in permanent life insurance policies. But many policyholders don’t realize they need to pay back the loan. They continue making the scheduled policy premium payments thinking the remaining cash value will carry the policy. If the loan is not paid back, interest starts to accrue and eventually the policy can lapse. The premium payment and/or residual cash value may not be adequate to cover both the interest on the loan and the cost of insurance that is withdrawn each month. The cost basis of a policy is the cumulative amount of gross premium that you have paid over the years, less any withdrawals.

Buying Based on Price

Buying life insurance policy based just on price could be a mistake. It is usually worth shopping around and sometimes paying a little higher premium for a policy that allows you to reduce the face amount of coverage, if desired, as well as to convert all or a part to a permanent policy through at least age of 65. Check the fine print; some policies limit reductions in coverage as well as what kind of permanent policy is available for conversion. 

Surrendering a Policy

If you possess a permanent policy and no longer need the coverage, don not just surrender the policy. You might have a taxable gain if the accumulated cash value exceeds your cost basis. And do n0t just transfer the entire cash value to an annuity. An annuity has less promising tax treatment and requires taxable earnings to be distributed first, followed by the tax-free return of basis. The cash value can continue to grow, and you can take distributions as desired, subject to the contract surrender schedule. All of the distributions would be taxable.