PERFORMING A LIFE INSURANCE POLICY CHECKUP FOR YOUR CLIENTS

Part 2

Step 4 - Identify the Policy Owner. If, within three years of death, the insured has any incidents of ownership (i.e., ownership rights) in a policy, the death benefit is included in the insured's estate. Thus, as illustrated by Example 3-4, policy ownership can be a critical issue if the insured is expected to have a taxable estate.

One of the best ways to keep life insurance proceeds out of an estate and ensure that the estate has the necessary amount of liquidity is to create an irrevocable life insurance trust. See section 502.

Step 5 - Identify the Policy Beneficiaries. Clients' circumstances change: children grow up and get married, grandchildren are born, deaths and divorces occur. Each of these events can affect who clients desire to name as beneficiaries on their life insurance policies. Yet, individuals frequently fail to update their beneficiary designations as often as they should. The consequences can be disastrous.

Example: Improper beneficiary designation.

Meryl purchased a life insurance policy on herself that named George, her husband, as primary beneficiary and their children as contingent beneficiaries. Several years later, Meryl and George were divorced and Meryl was killed in a car accident just months after the divorce was final. At the time of her death, Meryl's life insurance policy still named George as the beneficiary. In many cases, this means her former husband will receive all of the insurance proceeds and her children will receive nothing. (In some states, state law effectively removes an ex_spouse as a life insurance beneficiary on the date of the divorce, even when the policy owner fails to act.)

Note: Always check the life insurance beneficiary designations for divorced clients and remove the ex-spouse unless the divorce agreement requires insurance coverage for him or her.

Sometimes the problem with a named beneficiary is more subtle than in Example 3-5. For example, if a wife owns a policy or a community property interest in a policy on her husband and names her children as beneficiaries, the death proceeds are treated as a gift from her to the children at the time of the husband's death (Adele F. Goodman; Rev. Rul. 73-207). To avoid this gift tax liability, the policy could be owned by an irrevocable trust. Funds transferred to the trust to pay the premiums will be treated as gifts, but the death proceeds will not. For additional guidance on beneficiary selection, see section 501. For a thorough discussion of life insurance trusts and the income, estate, gift, and GST tax implications, see section 502.

Step 6 - Determine If the Amount of Coverage Is Adequate. Life insurance owned by younger clients is usually intended to provide replacement income if the primary provider dies prematurely (see paragraph 301.15). Addressing a client's income level and the amount of insurance needed to protect this income stream should be a natural lead-in to a discussion on preparing a more thorough financial plan for the client.

Life insurance owned by older clients and entrepreneurs of all ages is often used as a vehicle for estate liquidity or business succession. This should provide an opportunity for the planner to discuss estate planning with the client. Refer to section 301 for information regarding the adequacy of life insurance coverage.

Step 7 . Review a Policy's In-force Illustrations. Ask the client's insurance agent to obtain in-force illustrations for each policy showing the premiums, cash values, and death benefits to age 100. In addition, ask for illustrations at 1% and 2% below the current interest rate for whole life and universal life policies. For variable life policies, ask for illustrations projected at gross rates of return at 6% and 8%. The purpose of this exercise is to plan for possible changes in required premium outlays. The client may have been told a universal life policy had an estimated nine-year pay-in at the time it was taken out 10 years ago. But, based on current low interest rates, the client may in fact be facing another 10 to 15 years of premium payments (before policy interest credits and cash value will be large enough to cover the premium).

The policy review should include an evaluation of the policy's pricing. For example, term insurance rates have decreased significantly over the last 10 years. Replacing an old term policy with a new one can save the client money, assuming he qualifies for the new insurance at favorable rates. One disadvantage is that the new policy has a new two year contestability period.

Similarly, mortality charges in old universal life policies are often higher than those in the newer products. However, replacement of a policy with cash value requires a careful evaluation of surrender charges, possible income taxes, and future premium requirements. The newer universal life (UL) policies offer secondary guarantees, i.e., death benefits are guaranteed if a minimum level premium is paid each year (see paragraph 401.21). These policies are very popular because they eliminate investment risk and premiums are relatively low. However, the guaranteed UL Policies do not accumulate significant cash values over the long term. This product may be suitable for a client who wants the death benefit rather than cash value, such as when insurance is needed for estate liquidity.

Practice Tip: If possible, review in-force insurance illustrations every year with the client to avoid unpleasant surprises regarding protected premium outlays.

Step 8 - Be Aware of Important Tax Rules. A decedent's taxable estate includes the proceeds of life insurance policies payable to (or benefiting) the estate. In addition, life insurance proceeds that neither flow to nor benefit the estate are nonetheless subject to estate tax if the decedent possessed any incidents of ownership in the policy within the three_year period prior to death [IRC Secs. 2035(a) and 2042]. However, in spite of these seemingly broad tax rules, an individual's estate plan can normally be crafted in a manner that successfully protects life insurance proceeds from estate tax. See section 202 for coverage of this issue and section 201 for protecting life insurance proceeds from income taxation. See Appendix 3G for a checklist of items to be covered in reviewing a client's insurance and liquidity needs.