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Money June 2016

Dollar Sense

Life Insurance: A Few Things You Need to Know

By Teresa Ambord

Under normal circumstances, a paid-up life insurance policy will at least help pay for your final expenses, and possibly much more. Depending on the type of policy, it may also help pay the costs of long-term care, should you need it.

Life insurance can be a great backstop against the debts you may leave when you’re gone, the costs that may be incurred such as medical bills, and your funeral. The cost of a funeral alone is around $10,000. That’s why many people seek to insulate their heirs from hefty expenditures, or of course, to provide for them in the future.

Unfortunately there are times when life insurance doesn’t pay off, known as exclusions. And depending on the details, there might be hefty taxes associated with the payout. A book by attorney David G. Hoffman, The Essential Executor’s Handbook, provides solid information about life insurance, estates, and many other issues you may have questions about.

Here are exclusions which will result in no payout, or a payout to someone other than the intended beneficiary. Ideally, none of these situations will ever happen to you, but you might find them interesting.

  • Fraud in the contract. Applying for life insurance generally means you’ll answer tons of questions about your health and your family history (unless you apply for guaranteed acceptance or guaranteed issue life insurance).

    What happens if you hide information, for example a family history of heart disease? There’s a good chance the life insurance company will do some investigation. If they discover you hid information that is relevant, the policy could be void due to fraud. And that’s after you may have paid premiums for years. Not only have you wasted your money, but your survivors who counted on that policy to pay your final expenses will be left with unexpected bills.

  • Murder? Not that you’d consider this, but it does happen and not just in the movies. Can a murderer who is the beneficiary of the victim’s life insurance collect? The answer should be obvious. Criminal law says you cannot benefit financially from your crime.

    Suppose the victim was insured for a million dollars. Does the life insurance company just keep that money? According to Hoffman, the insurer may pay the proceeds to the estate of the victim. Then the estate will pay the victim’s other beneficiaries, but not you.

  • Suicide? I’ve always heard that life insurance doesn’t pay when the insured commits suicide, but lately I’ve heard of cases where they did. What’s the deal? Hoffman says it depends on the state, for one thing. Some states don’t require insurers to pay if the insured commits suicide within a year or two of initiating the policy. If a person requests a policy with a payout of $1 million or more, the insurer may conduct a mental and physical evaluation before writing the policy.

 

Taxability of Life Insurance Proceeds

Good news! If you receive a life insurance payout, that’s one of the very few things that the IRS doesn’t grab for federal income tax. This is true even though you can use it to pay expenses that are tax deductible, such as mortgage interest. The Executor’s Handbook calls it the perfect asset, for that reason.

That’s not to say life insurance may not be subject to federal estate tax. The key is… who owned the policy? Let’s say you just got a life insurance payout on Uncle Rex. If his employer owned the policy and you are the beneficiary, the proceeds should be exempt, at least from federal estate tax.

If Uncle Rex owned the policy, the payout is most likely subject to the federal estate tax, and possibly your state’s estate tax if there is one. However, this only applies if Uncle Rex’s estate was large enough to push the beyond the federal estate tax exemption, which in 2016 is $5,450,000 and the tax rate is 40%.

A legitimate strategy for bypassing this tax is to establish a trust which will own your policy. Ask your financial adviser about setting up an Irrevocable Life Insurance Trust (ILIT). If Uncle Rex had established an ILIT, the trustee (maybe you) could be the owner and the beneficiary of the policy. That avoids the federal estate tax, which can take a huge bite out of the proceeds.

Interest income earned on the death benefit will be taxed, however, as interest income.

 

Life Insurance May Help Pay for Long-Term Care

While long-term care insurance from a reputable company is a good thing, with any luck, you won’t need it. With life insurance, of course, we’re all going to die at some point. So under normal circumstances, a paid-up life insurance policy will at least help pay for your final expenses, and possibly much more. Depending on the type of policy, it may also help pay the costs of long-term care, should you need it.

Here’s a brief look at some policies that may pay a percentage of the face value towards the cost of long-term care.

Life settlements are a type of policy which allows the owner to sell the policies for cash, after a certain age. Generally these policies are only offered to men over age 70 and women over age 74. People tend to buy life settlement policies for the express purpose of someday paying for long-term care, should it become necessary. These policies require no health screenings.

Accelerated Death Benefits (ADBs) are offered as part of some life insurance policies. They may or may not add to the cost of your policy. ADBs serve different purposes, including extended nursing home care. Be sure to tell your agent what your goal is, and double check to ensure you know what you’re getting. The benefits available for long-term care won’t likely cover the full cost (and neither will long-term care insurance), but it will help defray the cost. The benefit may equal about 1% or 2% of the face value of the policy. These policies generally don’t require health screenings, though they may, so be sure to ask.

Viatical Settlements are a type of insurance which permits you, as the holder, to sell your policy to a third party in exchange for funding to pay long-term care costs. These policies, however, are only available to the terminally ill. No health screenings are required, and the amount of the benefit you can buy depends on your life expectancy.

Learn more about these and other policies at longtermcare.gov. Again, be sure your agent knows that you want insurance that will help with long-term care if you should need it.

 

Teresa Ambord is a former accountant and Enrolled Agent with the IRS. Now she writes full time from her home, mostly for business, and about family when the inspiration strikes.

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