Here are 6 Mistakes That Cost Millions.

Most people think life insurance is tax-free, and that’s how most of the agents in the marketplace promote it – but a simple mistake in ownership or transfer can trigger massive estate, gift, capital gains, and income taxes.

This article breaks down the six most common policy blunders that can turn a tax-free payout into a taxable nightmare for your family.

MISTAKE 1: Holding Your Own Policy

If you own the policy on your life, the death benefit is included in your gross estate for federal estate tax calculations.

This mistake applies even if the policy is intended to pay for the estate taxes itself, creating a vicious cycle of tax liability.

The entire death benefit – not just the cash value – is added to your taxable estate if you possess any “incidents of ownership.”

Incidents of ownership include the right to change the beneficiary, borrow against the cash value, or cancel the policy. We have published several articles on this topic of “incidents of ownership”, because it will inevitably determine how your beneficiaries receive insurance proceeds.

Takeaway: High-net-worth individuals must transfer ownership to a spouse, child, or, most commonly, an Irrevocable Life Insurance Trust (ILIT) to remove the proceeds from the estate.

MISTAKE 2: Violating the “Transfer for Value” Rule

The transfer for value rule is a lethal income tax trap for policies that have been sold or transferred for consideration, or anything of value.

If the rule is triggered, the tax-free status of the death benefit is lost, and the beneficiary must pay income tax on the amount exceeding the policy’s cost basis.

This is often accidentally triggered in business buy-sell agreements or when a policy is sold to another person to cover outstanding debts.

For example, if a partner buys a life insurance policy from another partner in the business, this transfer is a violation and creates an income tax problem.

Transferring a policy to an ILIT is generally safe, but paying the trust’s premiums with a premium loan from the insured can be considered a transfer for value.

Takeaway: Never transfer a policy for money or other property unless the new owner is a statutorily excepted person, like the insured or a partner of the insured.

MISTAKE 3: Not Reporting the Policy as a Taxable Gift

When you transfer ownership of an existing policy to another person or a trust, you are making a gift subject to federal gift tax rules. We have several articles that break down how GIFT TAXES are triggered in the Learn The Law section.

The value of the gift is typically the policy’s interpolated terminal reserve (ITR) plus any unearned premium, which is close to the cash surrender value.

If the value of the gift exceeds the annual exclusion amount, currently $19,000 for 2025, you must file a federal gift tax return.

Failing to file this return, even if no tax is due due to the lifetime exemption, can result in penalties and future scrutiny from the IRS.

When an ILIT is the owner, premium payments you make to the ILIT are also considered gifts to the trust’s beneficiaries.

Takeaway: Always work with a tax advisor to properly value and report the transfer of an existing life insurance policy, even if you are using your lifetime exclusion. The failure to file the Gift Tax Form, coupled with the incidents of ownership, can loop your assets back into your taxable estate.

MISTAKE 4: Cashing in the Policy for Profit (Income Tax)

While the death benefit is generally income tax-free, selling or surrendering a policy during your lifetime can create taxable income.

If the cash surrender value you receive is greater than your basis—the total premiums paid less any tax-free dividends—the gain is taxable as ordinary income.

This is not technically a capital gain, but it is a taxable gain on the investment component of the permanent life insurance policy.

For example, if you paid $100,000 in premiums and receive $150,000 in cash value, the $50,000 profit is immediately taxable as ordinary income.

This mistake often occurs when retirees attempt to use their policy’s cash value as a source of retirement income without proper planning.

Takeaway: Utilize tax-free policy loans or withdrawals up to your basis first, or consider a 1035 exchange to defer the tax on the gain.

MISTAKE 5: Falling Victim to the Three-Year Rule

If you transfer a life insurance policy and die within three years of the transfer date, the policy’s full death benefit is pulled back into your taxable estate.

This strict rule is designed to prevent death-bed transfers that attempt to avoid estate tax at the last minute.

Even if the policy was transferred as a valid gift (Mistake 3) and you filed the correct paperwork, the proceeds will be includible if you don’t survive the window.

This is one of the most punitive estate tax rules, effectively rendering the estate planning transfer useless if the insured dies prematurely.

Takeaway: The three-year period starts on the date of policy assignment, so plan your transfers well in advance, ideally when you are young and healthy.

MISTAKE 6: Gifting a Policy Subject to a Loan (Income Tax)

When you gift a policy that has an outstanding loan that exceeds your income tax basis (premiums paid), the transaction can be treated as a “sale.”

This is known as a bargain sale or net gift, where the transferor is relieved of a liability and receives “consideration” in the amount of the loan.

The transferor must recognize taxable income to the extent the policy loan exceeds the policy’s cost basis immediately upon the gift.

This mistake turns a benevolent act of gifting an asset into an unintended and immediate income tax liability for the policy’s original owner.

Takeaway: Before gifting a policy, either pay off all outstanding loans or ensure the loan balance is significantly less than the total premiums you have paid.

Do you think you might be violating some of these rules? If so, which one?

Leave your comments, or ask questions below…

Talk soon,
Sid Peddinti

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Life insurance is a powerful tool, but its tax advantages are conditional.

Always review your ownership, beneficiary, and premium payment structures with a qualified estate planning attorney and tax professional.

Don’t let a simple oversight turn a million-dollar benefit into a million-dollar tax bill.

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