Life Insurance Buying Basics

In this third segment of our six part series with money personality Terry Savage, we ask her to share some often overlooked tips about buying life insurance.

TC: Previously you told us about the types of insurance available and how the price can vary. What else should someone know prior to buying life insurance?

Savage: There are several simple, but important practical matters you should know before you buy a new life insurance policy. First, let’s talk about ownership of the policy.

I caution you to consult with an estate planning attorney before purchasing and titling your life insurance policy to avoid complications that might arise after your death. That said, here are a few basic guidelines to follow.

Who should be the policy owner? You’re buying life insurance, so it’s natural to think that you should own the policy itself. But, there’s a big difference between the policy owner and the beneficiary -- the person you name to receive the proceeds at your death. Owning your own life insurance policy is not always the best idea.

Your beneficiary will receive the payout from your policy tax-free. But if you are the owner of your policy, the value of that payout is included in your estate – potentially subjecting it to estate taxes. The tax law currently says that estates valued at $ 5.25 million or less are not subject to estate taxes. But above that amount, taxes rise quickly to a 40% rate.1

Your estate includes your home, property, investments, and the value of your retirement accounts. They may not add up to $5.25 million now, but could reach that level before you die – or the estate tax exemption could be lowered by a future Congress.

Changing a beneficiary is easy, but it is more difficult to change the name of the policy owner. And if you do change the name, the insurance company has a two-year window to contest the policy if you should die in that time period. So, you want to get it right the first time.

TC: What else can people do to keep taxes from reducing the payout?

Savage: Many people purchase life insurance in the name of an Irrevocable Life Insurance trust – to keep the proceeds out of their taxable estate. Every year, you can make a gift of money to the trust, which your chosen trustees will use to pay the premiums. At your death, the trustees can use the money to pay estate taxes, or distribute it according to your written instructions.

On the other hand, if you plan to accumulate cash inside the policy, and then potentially take a loan on it in the future, you will need to be the owner of the policy to accomplish that task.

TC: What tips can you offer about naming a beneficiary?

Savage: As noted above, you can always change the beneficiary of your policy, as long as you are the owner. There might be good reasons for doing so – as in the case of a divorce, when you no longer want your ex-spouse to receive the cash. (Note to women whose divorce settlement is secured by cash: You should be the owner, as well as the beneficiary of this policy.) As your life changes, remember to update your beneficiary – a simple process.

The beneficiary of a life insurance policy does not have to be a person. Many times a trust will be created to be the beneficiary, typically a revocable living trust. You name the trustees for this trust, and leave written, legal instructions as to how the trust proceeds are to be distributed.

TC: is it okay to name your children as beneficiary?

Savage: You should not leave life insurance proceeds to minor children (typically under age 18, but check your state law). If you do not set up a trust to receive the proceeds, the legal system will get involved, making decisions about distribution of the money. A trust allows you to delay payouts until some milestone is achieved, either age or perhaps college graduation. And the trust can specify that payments must be made for education, as opposed to an 18 year old deciding that the money should be spent on a sports car.

TC: If someone already has insurance, should they cancel it if they buy a new policy?

Savage: There may be reasons to give up, or surrender, an old policy. But those reasons are few, and you should never just give up or cash in your old policy, giving up the accumulated tax-deferred benefits.

There may be some good reasons for getting out of an older policy that has not performed well or one that has poorer investment choices for accumulating cash value. But beware, there may be surrender charges for these policies, or the cash you invested may not fully be returned if you give up the policy in your initial years. (TIAA-CREF cash value policies famously do not have surrender charges.)

An insurance agent earns most of his/her commission on the initial premium you pay for a new policy. That tends to encourage agents to suggest that people switch to a newer, better policy. In fact, many major insurers now require you to sign a document that says you are not giving up an older policy in order to make a new purchase, without a complete understanding of the consequences.

The consequences of switching policies may be a taxable gain – unless you do a 1035 tax-free exchange from the old policy to the new one. That provision of the tax code allows you to make a switch without incurring taxes. But it doesn’t protect you from fees and charges that may apply as you exit your old policy. Deal with this by simply asking how much your policy is worth now – and how much you could take out of the new policy if you change your mind next year!

TC: Any more tips to share?

Savage: When you purchase your policy, set up an annual system, not only for paying the premiums, but also for tracking the policy.

It’s tempting to think that after you buy your insurance policy you can simply pay the premium every year and never think about it again! In fact, with simple term insurance that is exactly what you can do – unless you’re thinking of converting to a cash value policy that will extend beyond the initial term.

But if you have a policy that includes choice about investments within the policy, and the amount of premiums paid each year to keep the policy going, then you really must do an annual checkup of how your policy is performing.

Just because your agent showed you some illustrations about the growth inside the policy, and the future premiums you would be paying to keep the policy in force, there is no guarantee with these policies. A few years of bad investment returns, or a low interest crediting rate, could force you to come up with higher premiums to keep the insurance going – just at the time you are least able to pay.

Every year you should ask for an in force ledger – a current projection (not guarantee) of how well your policy is funded, based on internal growth. Then you might decide to pay higher premiums, or reduce the face value. But don’t wait until the insurer asks you to pay more into the policy. Be proactive.

Finally, organize your entire financial life so that in an emergency your family would be able to find the important documents, such as your life insurance policy, if you were not around to direct them. Start with the Fiscal Fitness Review booklet on TIAA-CREF’s website. It will let your family now where everything is – from your insurance policies and will, to the cemetery deed, and investment and checking accounts. And it will serve as a checklist for the things that you should be doing now – before a crisis. That’s The Savage Truth.

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