7 Mistakes to Avoid When Purchasing Life Insurance

Buying life insurance is one of the most important decisions you are going to make. 

You buy it to protect your family from getting caught out financially.

I know most people think that it’s a straightforward thing to do – buy a policy and get covered, and that’s all there is to it.

I hate to break the bad news, but even with life insurance, things can go wrong and bite you in the behind if you don’t do it right.

Yup, buying life insurance has its perils, so I’m going to talk about some seemingly innocent mistakes that can cost you big if you’re not careful.

Here are 7 common mistakes that some people make all the time.

Pay close attention so you don’t get caught out, or act quickly to change your policy if you find you’ve already made one of these unfortunate blunders.

“Don’t make these mistakes when buying life insurance.”

Do Your Homework

Not all life insurance policies are the same, and not all policies meet your own specific and very unique needs.

Don’t make the mistake of just picking a life insurance policy out of a hat for the sake of convenience.

Sit down and talk out your own individual situation with an insurance broker you are comfortable with and don’t buy without knowing something about the life insurance company where you’re thinking of purchasing your policy.

The “Unholy Trinity” of Life Insurance Policies

Most policies consist of a policy holder with a named beneficiary.  For example, think of yourself as the policy owner/insured of the life insurance with your spouse as the beneficiary.

If you were to die under a term life policy for example, your spouse would get the designated death benefits and these benefits would be tax free.

Heck, practically everybody who has bought a policy knows that the death benefits are always going to be income and gift tax free, right?

Wrong!  In the example above, that’s the way it works, but not everybody has structured their policy that way.  This is where the unholy trinity comes into play.

Some people have their life insurance structured slightly different where there are actually 3 different parties involved.

First, there is the owner of the policy (the person who bought the policy), the person being insured (someone who is different from the owner of the policy), and the beneficiary.

An example would be a father buys a life insurance policy (owner) for his son (the insured), and the son’s wife is the named beneficiary.

If the son dies, then his wife gets income tax free death benefits, but because the way the tax people look at it, the wife is getting a gift from her husband’s father, the owner of the policy and this gift is taxable to the father.

The lesson here is that the owner and the named insured of a life insurance policy or the owner and beneficiary must be the same person.

The Business Insurance Policy Unholy Trinity

Many business people also own life insurance to protect their families, to cover costs associated to their business, and to see that their loved ones get tax free money.

Unfortunately, they may have stumbled into the bad luck scenario that happened above.

The unholy trinity for a business would be where 1) the business buys the policy  2) the owner of the business is the named insured and 3) a member of their family is the named beneficiary.

In the previous scenario, the father ended up having to pay a gift tax, but in the business scenario, it’s going to be worse, because now the beneficiary would be subjected to paying income tax.

It boils down to how you structure it again –  the owner of the policy and the named insured has to be the same person.

The Estate as Beneficiary

Never deliberately use your estate as the named beneficiary.

Also, if you have a named a beneficiary and they die before you do, the estate automatically becomes the beneficiary unless you change it otherwise.

You never want the estate to be the beneficiary of your life insurance policy because it opens a whole can of worms such as possibly being required to go into probate, receiving claims from creditors, and becoming subject to inheritance or estate taxes as a result.

Always make sure you have a named beneficiary on your policy.

Key Employee Life Insurance Mistake

Many companies buy life insurance on their key employees for a variety of reasons.

You might know that after August 17, 2006 that generally, all employer owned life insurance contracts purchased for key employees are subject to income tax.

However, you can get around this potential tax mess if specific employee notice and requirements are met because there are exceptions that do apply, so the rule is not as rigid as it appears.

The important thing to note is that these employee notice and requirements must be met before the policy is issued.

If you were under the impression you were going to use these notices and requirements to avoid taxes after the fact, then you will be out of luck.

You will have to talk to broker about re-issuing the policy the proper way to reap any possibility of tax deductible death benefits.

Changing a Policy after Taking a Loan

Permanent life insurance policies such as whole life, for example, have a cash accumulation value.

After a certain point in the life of the policy, you are allowed to borrow against that cash value.  If you have done so, and then decide to change your existing policy, the status of the loan can change as well.

The reason is because if the new policy does not contain a carry over of the loan you took out on the old policy, its status changes to that of a gift and becomes taxable.

Taking a Loan or Using the Cash Value as Retirement Funds

Most people use permanent life insurance polices to either borrow against or use for their retirement, and believe that the funds will automatically be non-taxable.  Wrong!

Some time back, Congress enacted into the Internal Revenue Code a provision known as the ‘cash rich rule’.

After 1984, a portion of policy benefits which are issued against a policy before 15 years have elapsed during the life of the policy, may be subject to income tax.

If you plan to access funds as a loan or use towards your retirement, wait until year sixteen of the policy to avoid these potential tax complications.

Lying on Your Application

All of us want to save money on our insurance rates and most of you folks out there want to do so legitimately.

Unfortunately, there’s a small group who thinks it’s a good idea to scam or pull a fast one on the insurance company.

Bad move!  Insurance companies have been doing their thing for a couple hundred plus years.  If you don’t think they don’t know every trick in the book then you’re deluding yourself.

So, what if you get caught – what’s the worst thing that could happen?

By trying to gyp the insurance company out of a few bucks your foolishness could end up leaving your family in a world of financial hurt.

Your life insurance claim might end up being challenged and declined while leaving your loved to clean up the mess and pick up the pieces.

Is this smart?  Is this the legacy you want to leave behind?  Of course it’s not!

Need help applying for life insurance without making these mistakes?  Call us at 888-603-2876.

*While we make every effort to keep our site updated, please be aware that "timely" information on this page, such as quote estimates, or pertinent details about companies, may only be accurate as of its last edit day. Huntley Wealth & Insurance Services and its representatives do not give legal or tax advice. Please consult your own legal or tax adviser.