5 Mistakes in Life Insurance Planning

5 Mistakes in Life Insurance Planning

Author Executive Benefits Team
Date August 5, 2020

More than three years ago, we first published an in-depth look at 5 mistakes in life insurance planning. Despite shifts in politics and the economy, tax code changes, and other variables of life, the facts remain the same. In personal life insurance planning, particularly as part of estate planning, even minor oversights can lead to major tax problems.

Recognizing that efforts to reduce cost in the short term could lead to problems, we’re resharing this important information on 5 key trouble spots in life insurance planning. The report was first published on WRNewswire and WRMarketplace by the Association for Advanced Life Underwriting® as part of the Essential Wisdom Series. You can read the full report here.

Your Checklist: 5 Mistakes in Life Insurance Planning

  1. Failure to Qualify for Annual Exclusion Gifts
  2. Improper GST (generation-skipping transfer) Tax Exemption Allocation to ILITs (irrevocable life insurance trusts)
  3. Incidents of Ownership in ILIT-Owned Policies
  4. Failure to Understand Implications of a MEC (modified endowment contract)
  5. Creation Of “Taxable” 1035 Policy Exchanges

Overview of 5 Life Insurance Planning Mistakes

For more information along with practical insights and examples, be sure to read the complete article, available here as a PDF download.

Failure to Qualify for Annual Exclusion Gifts

ILITs are not “set it and forget it” propositions. People may rely on the annual exclusion from gift tax (“annual gift exclusion”) to make gifts to their irrevocable life insurance trusts to fund premiums.1 A gift only qualifies for the annual gift exclusion if the recipient has a “present interest” in the gift, and gifts to ILITs typically do not satisfy this requirement.

Improper GST Tax Exemption Allocation to ILITs

The annual exclusion from generation-skipping transfer (GST) tax requires that the trust receiving the gift must (1) benefit only one individual during his/ her life (who is a skip person for GST tax purposes (e.g., a grandchild)) and (2) the trust assets must be paid to that individual during life or be includible in his gross estate at death. Gifts to typical ILITs will not qualify for the annual GST tax exclusion.

Incidents of Ownership in ILIT-Owned Policies

An insured that retains any “incident of ownership” over a policy at death, whether individually or through a trust, will trigger inclusion of the policy proceeds in his or her estate. “Incidents of ownership” extend well beyond the holding of title to a policy and include, for example, the insured’s ability to change beneficiaries or to access policy cash value, including the power to pledge the policy for a loan (e.g., coverage on a business owner pledged as collateral for a line of credit).

Failure to Understand Implications of a MEC

For most life insurance contracts, withdrawals of policy cash value by the policy owner are not taxable, up to the owner’s tax basis in the policy. A different rule applies to life insurance contracts classified as modified endowment contracts (MECs).2

Creation Of “Taxable” 1035 Policy Exchanges

Code §1035(a) allows the exchange of one life insurance contract for another, generally without the recognition of gain or loss upon the exchange (a “1035 exchange”).This provision allows the deferral of taxation for individuals who merely exchange one policy for another better suited to their needs. 1035 exchanges are popular because they permit clients to adapt their long-term life insurance planning to changed economic and family circumstances, but they must be carefully implemented with full awareness of related issues and caveats that may apply.

Life insurance remains one of the best ways to protect your family, your business, and your wealth. Taking advantage of it strategically requires knowledgeable guidance and expertise.

#lifeinsurance #lifeinsurancemistakes #estateplanning


1 Generally, a person’s first $15,000 (in 2020, indexed) of annual gifts to a donee is excluded from federal gift tax.

2 A MEC is a life insurance contract that: (1) is entered into or materially changed after June 21, 1988, and (2) fails the “seven-pay test” (see Code §7702A). A policy fails this test if at any time in the first seven years, the total premiums paid for the policy exceed the total net level premiums that would have been paid up to that point for a fully paid-up policy requiring seven level annual premiums (see Code §7702A(b); §7702A(c)).


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This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, accounting, legal or tax advice. Any tax advice contained herein is of a general nature. You should seek specific advice from your tax professional before pursuing any idea contemplated herein.

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