Understanding Life Insurance: Incidents Of Ownership Explained

Incidents of ownership is a term used to denote the possession or retainment of certain rights or benefits over property. This term is often used in life insurance or property disputes. In the context of life insurance, incidents of ownership refer to the rights of a person or trustee to change beneficiaries, borrow from the cash component, or alter the policy in some way. This becomes relevant when determining tax responsibility in cases where a life insurance policy is gifted to another person or entity.

The right to change beneficiaries

Understanding Incidents of Ownership

Incidents of ownership refer to the rights of a person or trustee to make changes to a life insurance policy. This includes altering the beneficiaries, borrowing from the policy's cash value, or otherwise modifying the policy. These rights are associated with the policyholder, even if they choose not to exercise them.

The policyholder, who purchases the contract and pays premiums to the insurance company, has the right to change the beneficiaries at any time. This means they can decide who will receive the death benefit payout if the insured person passes away. It is important to document these changes to ensure they are legally valid.

Types of Beneficiaries

There are two main types of beneficiaries: primary and contingent. A primary beneficiary is the first in line to receive the death benefit, while a contingent beneficiary serves as a backup if the primary beneficiary is unable to receive the payout. Policyholders can name multiple beneficiaries of either type to ensure their wishes are carried out.

Beneficiary Changes and Taxes

It is important to note that changing beneficiaries can have tax implications. If the insured person has incidents of ownership, including the right to change beneficiaries, the death benefit may be included in their taxable estate. This can result in an estate tax, even if the policy is not directly owned by the insured.

Avoiding Disputes

To avoid disputes, policyholders should follow a few guidelines. It is essential to update beneficiaries as needed, especially after major life events like divorce. Adhering to the insurance company's procedures for beneficiary changes and discussing these changes with loved ones can also help prevent disputes.

Timing of Changes

While policyholders can change beneficiaries at any time, it is important to note that beneficiary changes cannot be made after the policyholder's death. Therefore, it is crucial to make any desired changes while the policyholder is still alive and to follow the necessary procedures outlined by the insurance company.

Borrowing from the cash value

When borrowing against the cash value of a life insurance policy, there is typically no approval process or credit check required. The only requirement is that you have sufficient cash value built up in your policy, and the minimum amount required varies by insurer. It's worth noting that the limit for borrowing is usually set by the insurer, and it's typically no more than 90% of the policy's cash value. Additionally, it may take several years for a newer policy to accrue enough value to borrow against.

Another important consideration is the impact on the death benefit. If you pass away with an outstanding loan on your life insurance policy, the insurer will deduct the amount owed from the death benefit, resulting in a reduced payout for your beneficiaries. Therefore, it is crucial to have a solid plan to repay the loan. While there is no set repayment schedule for life insurance loans, interest will accrue on the balance, increasing the amount owed over time.

Furthermore, if the loan balance becomes too high, it could cause the policy to lapse or be surrendered. In such cases, the insurance company will use the cash proceeds from the surrender to pay off the loan balance, and you may owe additional taxes on the gain. Therefore, it is essential to work with a financial advisor to understand the potential tax implications and create a repayment plan that aligns with your financial situation.

Overall, borrowing from the cash value of a life insurance policy can provide quick access to cash with flexible repayment options. However, it is important to carefully weigh the benefits against the potential risks, such as reduced death benefits and possible tax consequences, to ensure it is the right decision for your financial needs.

Assigning the policy

Assigning a life insurance policy to someone else is a complex process. It involves transferring all rights and ownership of the policy to another person or legal entity. This is known as an absolute assignment.

If you want to proceed with an absolute assignment, you must notify your insurer, who will provide you with the necessary ownership forms. It's important to remember that this transfer is irrevocable – once you have assigned the policy to someone else, you cannot change your mind.

As the owner of a life insurance policy, you have complete control over it. You can decide to cancel, surrender, or gift the policy, change the beneficiaries, or update the allocations of death benefits. You can also choose how much coverage you want and how long the policy should last. However, as the insured person, you will remain insured even after transferring ownership, but the new owner will be able to make changes to the policy, including updating coverage and designating new beneficiaries.

There are several reasons why someone might want to transfer ownership of a life insurance policy. This could include estate tax planning or changes to financial or life circumstances, such as a divorce or new financial obligations. Transferring ownership of a policy can also be necessary when creating a life insurance trust or securing a business loan.

It's important to note that when transferring ownership, the original owner typically needs to give up all legal rights to the policy and should not pay the premiums. Additionally, if the insured person or transferor dies within three years of transferring the policy, the life insurance proceeds will be included in the gross value of the original owner's estate, according to the three-year rule.

Revoking an assignment

The Internal Revenue Service (IRS) will look for any incidents of ownership when a person gifts a life insurance policy to another person or entity. When transferring a policy, the original owner must give up all legal rights and must not pay the premiums to keep the policy in force. This is important because incidents of ownership can have tax implications for the owner of a life insurance policy. If the insured has incidents of ownership, the death benefit is included in the taxable estate of the insured. This means that the proceeds from the policy can be counted as part of the estate and may be subject to estate taxes.

To revoke an assignment of a life insurance policy, the owner of the policy must give up all rights to the policy, including the right to change beneficiaries, borrow from the policy, or make any other changes to the policy. The owner must also stop paying any premiums on the policy. It is important to note that if the insured or transferor dies within three years of the date the policy was transferred, the life insurance proceeds will be included in the gross value of the original owner's estate, according to the three-year rule.

Consulting with a knowledgeable attorney or estate planning attorney before making any changes to a life insurance policy is always recommended. They can help guide you through the process and ensure that you are complying with all legal requirements.

Using the policy as collateral

Using a life insurance policy as collateral for a loan is a financial strategy that can benefit both the borrower and the lender. This strategy is often used when someone is trying to launch a business or borrow money for another purpose. It is called a collateral assignment, and it acts as a lien against the proceeds of an insurance policy. In the event of the borrower's death before the loan is paid off, the lender will use the death benefit to pay off the outstanding loan balance, with any remaining funds going to the policy's beneficiaries.

Collateral assignment is often confused with borrowing money from your policy. The latter is a lending option for those with permanent life insurance, such as a whole life policy, that has accumulated cash value. While you are essentially borrowing from yourself in a life insurance loan, it is not without its potential perils. If you don't pay back the cash value taken from the policy, it will reduce the death benefit and could result in higher premiums if you were using the invested returns of the policy's cash value to offset premium costs.

Collateral assignment of your life insurance also has disadvantages. If you default on the loan, the lender will have first claim to your policy's death benefit. Therefore, it is crucial to understand this borrowing option and how to minimise its potential drawbacks.

Collateral assignment can be used for a car loan or mortgage, but it is often unnecessary as the home or car the loan helps to buy can become the collateral. Collateral assignment is most common in small-business lending. Since most entrepreneurs invest all their savings into their ventures, they might not have many sources of equity to tap into. In the case of a failed business venture, there might not be enough tangible assets of value for the lender to recoup their losses.

If you are required to have a policy naming your lender as a collateral assignee to get a business loan, this usually involves term life insurance. The term of the policy will likely need to be at least as long as the length of the loan. From the lender's perspective, the best way to get protection is to get an insurance policy for the length of the loan.

If you are trying to use the value of a life insurance policy to help secure a mortgage or other type of personal loan, the lender might prefer you to have a whole or permanent life policy with accrued cash value. This is because the cash value makes the policy a tangible asset, like a building or vehicle.

How to Apply for Collateral Assignment of Life Insurance

Before applying for collateral assignment, it is vital to know the requirements. Lenders generally require an active life insurance policy with cash value, which means a term life insurance policy may not qualify. However, exact requirements vary by lender. If you need to get a new life insurance policy, research and gather quotes from several insurance companies to choose the best option for you.

Once you've found a suitable policy, apply for life insurance. You will likely need life insurance with cash value. Check with the lender to ensure the policy qualifies for a life insurance collateral assignment before signing the contract.

Once you sign your life insurance contract and pay your first premiums, complete a collateral assignment form with your insurer. You will need to fill in your lender's contact details so your insurer can designate them as a collateral assignee while your loan is outstanding. After completing the form, you and your lender must sign it. Your insurer may be able to provide electronic versions of the documents and e-signature capabilities to streamline the process.

Wait for your bank to confirm that your insurer has made them the collateral assignee, and then apply for your chosen loan.

How Collateral Assignment May Affect Your Beneficiaries

Using your life insurance policy as collateral may impact your beneficiaries if you default on the loan or pass away with an outstanding balance. Either event could reduce the death benefit payout your beneficiaries receive. For example, if you take out a $50,000 loan using your $500,000 policy as collateral but pass away with a $40,000 loan balance, your lender can collect a portion of your death benefit, leaving your beneficiaries with less money.

Frequently asked questions