6 Common Life Insurance Mistakes Avoid

One of the most important aspects of anyone’s financial plan is life insurance.

However, there are many misconceptions about life insurance, owing to the way life insurance products have been sold in India over the years.

We’ve gone over some common blunders that insurance buyers should avoid when purchasing policies.

Underestimating the need for insurance:

Many life insurance buyers select their insurance covers or sum assured based on the plans that their agents want to sell and the amount of premium they can afford.

This is a bad strategy.

Your insurance needs are determined by your financial situation, not by the products that are available.

Many insurance buyers use rule of thumbs such as 10 times annual income as a guideline for coverage.

According to some financial advisors, a coverage of ten times your annual income is sufficient because it provides your family with ten years’ worth of income when you pass away.

However, this isn’t always the case. Assume you have a mortgage or home loan with a 20-year term.

How will your family pay the EMIs after ten years, when the loan is still in default for the most part? Assume you have a family with very young children.

Your family will run out of money when it is most needed, such as for your children’s higher education.

When determining how much insurance coverage is appropriate for them, insurance buyers must consider a number of factors.

Repayment of the policyholder’s entire outstanding debt (e.g., home loan, car loan, etc.)

After debt repayment, the cover or sum assured should have enough funds to generate enough monthly income to cover all of the policyholder’s dependents’ living expenses, taking inflation into account.

After debt repayment and monthly income generation, the sum assured should be sufficient to meet the policyholder’s future obligations, such as children’s education, marriage, and so on.

Choosing the cheapest policy

Many people prefer to purchase policies that are less expensive.

This is yet another serious blunder.

A low-cost policy is useless if the insurance company is unable to pay the claim in the event of an untimely death for some reason.

Even if the insurer honours the claim, if it takes an unreasonable amount of time, it is clearly not a desirable situation for the insured’s family.

If such an unfortunate situation arises, you should look at metrics like Claims Settlement Ratio and Duration wise settlement of death claims of different life insurance companies to select an insurer that will honour its obligation in fulfilling your claim in a timely manner.

The IRDA annual report contains data on these metrics for all Indian insurance companies (on the IRDA website).

You should also look up online claim settlement reviews before deciding on a company with a good track record of settling claims.

Buying the wrong life insurance plan and treating it as an investment:

A common misconception about life insurance is that it can be used as an investment or a retirement planning tool.

This misunderstanding is largely due to the fact that some insurance agents prefer to sell expensive policies in order to earn large commissions.

When compared to other investment options, life insurance simply does not make sense as an investment.

Equity is the best wealth creation instrument if you are a young investor with a long time horizon.

With the same investment, a 20-year investment in equity funds through SIP will result in a corpus that is at least three or four times the maturity amount of a 20-year term life insurance plan.

Life insurance should always be viewed as a means of providing financial security to your family in the event of an untimely death.

Investment should be treated as a distinct consideration.

Even though insurance companies market Unit Linked Insurance Plans (ULIPs) as attractive investment products, you should separate the insurance and investment components for your own evaluation and pay close attention to how much of your premium is allocated to investments.

Only a small portion of a ULIP policy’s initial investment is used to purchase units.

A good financial planner will always recommend that you purchase a term insurance policy.

A term plan is the most basic type of insurance and provides straightforward protection.

Term insurance plans have lower premiums than other types of insurance plans, leaving policyholders with a larger investible surplus to invest in investment products such as mutual funds, which provide much higher long-term returns than endowment or money-back plans.

If you have a term insurance policy, you may be able to supplement your term policy with other types of insurance (e.g., ULIP, endowment, or money back plans) depending on your specific financial needs.

Purchasing insurance for tax planning:

For many years, agents have persuaded their clients to purchase insurance plans in order to save money on taxes under Section 80C of the Internal Revenue Code.

Insurance is probably the worst tax-saving investment available to investors.

Insurance plans yield 5 to 6 percent returns, whereas Public Provident Funds, another 80C investment, yields close to 9% risk-free and tax-free returns.

Another 80C investment, Equity Linked Savings Schemes, provides much higher tax-free returns over time.

Furthermore, insurance plan returns may not be completely tax-free.

If the premiums exceed 20% of the sum assured, the maturity proceeds are taxable to that extent.

As previously stated, the most important thing to remember about life insurance is that its primary goal is to provide life insurance, not to maximise investment returns.

Giving up or withdrawing from a life insurance policy before it matures:

This is a serious mistake that jeopardises your family’s financial security in the event of a disaster.

Life insurance should not be touched until the insured person passes away.

Some policyholders surrender their policies to meet an immediate financial need, with the intention of replacing them once their financial situation improves.

Two things should be kept in mind by such policyholders.

To begin with, no one has control over their own mortality.

It is for this reason that we purchase life insurance in the first place.

Second, as the insurance buyer grows older, life insurance becomes prohibitively expensive.

In the event of financial distress, your financial plan should include contingency funds to cover any unexpected urgent expenses or provide liquidity for a period of time.

Insurance is a one-time investment:

I recall seeing an old motorcycle commercial on TV with the punch line, “Fill it, shut it, forget it.”

When it comes to life insurance, some people have the same mindset.

They believe that once they purchase adequate coverage in a good life insurance plan from a reputable company, their life insurance needs will be met for the rest of their lives.

This is a blunder.

Insurance buyers’ financial circumstances change over time.

Compare your current earnings to your earnings ten years ago.

Isn’t it true that your income has increased by a factor of ten?

Your way of life would have significantly improved as well.

If you purchased a life insurance policy based on your income ten years ago, the sum assured will not be sufficient to meet your family’s current lifestyle and needs in the unfortunate event of your untimely death.

As a result, you should purchase a second term plan to cover that risk.

Life insurance needs must be re-evaluated on a regular basis, and any additional sum assured, if necessary, must be purchased.

Conclusion

When purchasing insurance policies, investors should avoid making these common mistakes.

One of the most important aspects of anyone’s financial plan is life insurance.

As a result, life insurance must be given careful consideration.

Insurance buyers should be cautious of dubious sales tactics used in the life insurance industry.

It’s always a good idea to work with a financial planner who can look at your entire portfolio of investments and insurance on a holistic level, so you can make the best life insurance and investment decisions.

BONUS ARTICLE

Common Life Insurance Traps And How To Avoid Them

Beware of these common life insurance traps, which can reduce the value of your policy for your family… or leave you paying a lot of money to the IRS.

Having too much and for too long life insurance.

You’ll almost certainly need a substantial amount of life insurance during the years you’re working and raising a family to protect your family from the loss of your income.

Your insurance needs may be drastically reduced as you approach your senior years, with your children grown, the mortgage paid off, and retirement accounts funded.

For many people, owning life insurance is a way to pay off estate taxes.

However, recent tax law changes have reduced this need by raising the individual estate and gift tax exemption amount to $1 million.

By paying for unnecessary insurance coverage, you are foregoing the opportunity to invest in higher-yielding assets.

STRATEGY

Examine your insurance needs in light of any changes in your personal circumstances or potential estate tax liability.

Consider this if you have an excessive amount of insurance.

Investing in a tax-deferred annuity issued by an insurance company instead of life insurance to get a higher return. This can be accomplished through a tax-free exchange, which allows you to avoid paying taxes on the insurance policy’s disposition.

  • Giving your insurance policy to a good cause. The cost basis in the policy—generally, the amount of premiums you’ve paid into it—will qualify you for a tax deduction.
  • Giving the policy to your child or grandchild as a gift. The policy benefit will be tax-free to the recipient, providing the child with a significant financial advantage. If you survive three years after the gift, the policy will be removed from your taxable estate.
  • By utilising your annual gift tax exclusion (currently $10,000 per recipient, or $20,000 when gifts are made by a married couple) and, if necessary, a portion of your estate and gift tax exempt amount, you can avoid paying gift tax on the transfer.
  • It’s time to cash in the policy. This will put money in your pocket, but you will have taxable income if the amount you receive for the policy exceeds the amount you paid in premiums.

Estate tax planning:

If you still need life insurance to cover potential estate taxes, consider a second-to-die policy, which covers both you and your spouse and pays out on the survivor’s death.

Because the estate tax marital deduction allows all of one spouse’s assets to pass tax-free to the surviving spouse, a couple’s estate tax liability is due when the surviving spouse dies.

A second-to-die policy can provide funds to cover such an estate tax bill for a fraction of the cost of buying two separate insurance policies for each spouse.

TRAPS

  • Having your own life insurance policy. Because you die owning a policy on your own life, the proceeds are included in your taxable estate, this can subject insurance proceeds to estate tax at rates as high as 55 percent.

Avoid falling into this trap by transferring ownership of the policy to the policy beneficiary or establishing a life insurance trust to hold the policy and distribute the proceeds according to your wishes.

You can still pay for the policy’s premiums by making gifts to the policy owner (beneficiary or trust) and deducting the gifts from your annual gift tax exclusion.

Benefit:

When your life insurance is owned by your beneficiary, the proceeds are free of estate and income taxes.

Avoid these common blunder.

  • Purchasing life insurance for yourself and naming your spouse as a beneficiary. Due to the unlimited marital deduction, the insurance proceeds will be exempt from estate tax upon your death; however, if your spouse owns the proceeds when you die, they will be taxable in his or her estate.
  • Having life insurance on oneself and naming a third party as a beneficiary.

For instance, one spouse may own life insurance on the other’s life and name a child as the beneficiary.

Because the policy owner has control over the beneficiary designation, the payment of the benefit to the beneficiary is considered a taxable gift by the policy owner.

Avoid this trap by having the beneficiary own the life insurance policy, or by having the policy owned by a life insurance trust.

Important: If you want to own insurance through a life insurance trust, make sure the trust is drafted by an expert in the field.

Nonspecialists’ trust documents can easily contain erroneous bad language that fails to meet technical requirements, causing the trust to fail.

Loaning against a life insurance policy.

Borrowing against life insurance can be tempting because policy loans can provide a tax-free source of cash with a low interest rate.

However, borrowing against insurance could lead to a couple of pitfalls…

Borrowing against insurance reduces the insurance benefit for which you presumably purchased the insurance, putting your family at greater risk.

Risky scenario:

Typically, interest on an insurance loan is charged against the policy rather than paid in cash.

If the loan is not paid back and the interest compounded, the loan can grow until it equals the value of the policy.

The policy will then expire, and you will have taxable income equal to the unpaid loan (a “forgiven debt”) minus your policy basis, even though you will have no cash income with which to pay the tax.

The policy benefit may be subject to income tax if you borrow against insurance and then transfer the policy to another person.

When a borrowed-on policy is gifted, the recipient is deemed to have purchased the policy by assuming the outstanding loan obligation, with the assumed loan amount serving as the purchase price.

Furthermore, if the purchase price of an existing life insurance policy exceeds the donor’s basis in the policy, the policy benefit becomes taxable income to the purchaser.

Example:

A parent has a $500,000 life insurance policy with a $100,000 cash value on his or her own life.

In the policy, he has a cost basis of $60,000.

He takes out a $90,000 loan against the policy to reduce the cash value to $10,000, then gives the policy to a child.

As a result, by taking on the $90,000 loan obligation, the child is deemed to have purchased the policy.

As a result, instead of being tax-free, $410,000 of the policy benefit will be taxable income to the child when it is paid out.

FINAL THOUGHTS

Loans are problematic, so it’s best to avoid taking out life insurance loans.

If you’ve already taken out life insurance loans, have them reviewed by a professional to see if there are any unanticipated issues.

1 thought on “6 Common Life Insurance Mistakes Avoid in 2022”

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