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Preventing Tax Pitfalls With the Right Life Insurance Policy

The life insurance industry has a complex relationship with the U.S. tax code – even many seasoned insurance professionals don’t have full understanding of, or experience with, the code’s various intricacies and benefits.

In the life insurance world, our most valuable commodity is an intangible asset that provides liquidity at death. Often, potential clients fail to understand the importance of the right policy until it’s too late. What makes this even more challenging is widespread misinformation about the extraordinary value a life insurance policy represents.

And, since consumers often consider life insurance policies a luxury rather than a need, agents can unintentionally leave clients hanging over a tax cliff just to help close a sale.

In my 30 years in this industry, I’ve seen a variety of sales tactics – some successful, some less so – promulgated by agents and carriers in an attempt to take advantage of our tax code. Of course, a product that provides such significant financial advantages without manipulation shouldn’t require any fancy sales pitches. But tax benefits – particularly deductions for premium payments – often are the “grease that makes the wheels turn.” We’re in the business of ensuring our clients are satisfied, after all.

However, to avoid a tax conundrum, agents and industry professionals need a keen knowledge of a life insurance policy’s tax implications.

To shed some light on the ways inaccurate or misleading tax information can impact policyholders and their business and family, here’s a cautionary tale.

My team began working with a pair of business owners two years after they purchased (and had begun contributing to) policies with an aggregate annual premium of $2.6 million. This plan purported to conform to the U.S. Tax Code Section 419(e); it covered the owners and their families, but none of the other 160 employees.

When we provided a thorough review of the plan and the policies it owned, we identified several alarming and abusive tax practices.

We discovered the business owners’ life insurance policies were incompatible with their future goals – funding an estate tax liability. In fact, if the insurance had performed as illustrated – and unsurprisingly, it did not – it would have lapsed in fewer years than the insureds’ life expectancies.
Needless to say, these clients were unhappy to learn that their huge tax deduction was at risk and their coverage grossly inadequate.

Two years later, we received a call from their legal counsel, who informed us the Internal Revenue Service was in the process of auditing the company. It turned out we were spot on regarding the company’s overly aggressive tax deductions and inadequate coverage. The company was subject to fines and penalties; furthermore, the company’s owners filed a lawsuit against their life insurance agent for selling a fraudulent plan. To date, the case is still working its way through the courts.

After we learned about the fallout, we helped the family members and employees purchase life insurance coverage that was suitable for their needs, was guaranteed for life and cost less than half of their original policies. Most importantly, their new plans conform to the appropriate tax laws.

The lesson in all of this is simple: If a policy promises to outsmart the U.S. tax code, it probably will not. Agents who make unrealistic promises about a policy’s potential workarounds – through ignorance or overeagerness – are doing their clients a disservice and unnecessarily assuming the risk of being sued themselves.

It isn’t too late to correct noncompliant or flawed plans, though, and an annual policy audit can identify these errors and save clients money and headaches around tax time.

Striking a Balance: Finding the Right Benefit
Putting clients’ needs first includes finding the right tax benefits for a client’s individual policy and family or company needs.

I’ve seen too many misguided policyholders pay the price this time of year simply because they did not have access to the right information. In fact, the road to tax advantaged life insurance is littered with casualties; among them are Charitable Split Dollar, 419(e) Retired Lives Reserve (RLR) and Minimum Deposit, among others. These options stand out as overly aggressive and ultimately doomed strategies sometimes promoted by agents in the lead-up to tax season.

Each previously mentioned option actually began as a viable concept, but was ultimately corrupted by insurance agents or carriers seeking to meet the desire to deduct premiums or interest.
It’s important to remember that life insurance is one payment a policyholder can’t necessarily deduct unless it falls within specific, finite and ever-changing guidelines. As springtime approaches, it’s imperative to begin working with each individual client to determine the best tax strategy. Approach your clients with a personalized perspective to achieve positive results.

Best Practices Over Three Decades
To prevent unfortunate results for your clients during tax season, it’s important to keep the following practices in mind:

» Agents should never encourage clients to make large financial decisions based solely on a tax deduction, no matter how enticing.

» It’s the agent’s responsibility to ensure the plan is compliant with all Internal Revenue Code regulations. Agents can benefit significantly by identifying discrepancies in a plan and assisting the client with remediation and revised coverage.

» Always make sure the coverage you sell meets your clients’ intended needs and risk tolerance. Every client is different and every policyholder has different needs and expectations – treat each case individually.

» Clients should feel comfortable obtaining an unbiased second opinion from a third-party administrator unrelated to the agent or insurance carrier. An annual policy audit can uncover many of these risks before they become unmanageable or illegal.

With all of this said, the right life insurance product will provide the most tax-effective means to accumulate and distribute wealth. More specifically, the right plan provides two of the most important tax benefits – tax-deferred accumulation and potentially tax-free distribution.

In fact, that’s exactly how my wife, who’s also an insurance industry professional, and I are preparing for retirement. The right policy for our needs is currently providing us with an opportunity to accumulate wealth and receive tax-free income at retirement. Nothing is more effective or more worthwhile, and I encourage my team and their clients to do the same.

The working population under age 50 is, on average, woefully underinsured, yet it’s those same policyholders who can best take advantage of the unique tax characteristics of the right life insurance policy.

Navigation of the U.S. tax code can be complex, so don’t be tempted, or worse, tempt your clients, with shaky tax inducements. Savvy, successful professionals need to find the intersection of the right insurance plan and on-target, accurate tax benefits.


Ron Sussman is founder and chief executive officer of and CPI Companies. He counsels high-net-worth individuals through risk management analysis and life insurance planning strategies. Ron may be contacted at [email protected] [email protected].

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