Not too long ago, a worried and angry gentleman walked into our office. It seems as though he had been provided a great opportunity by an insurance agent acquaintance - a sort of "have your cake and eat it too" kind of an opportunity.

Here’s how the opportunity played out. First, this gentleman, let’s call him Mr. WA (for worried and angry), invested $25,000 in a single-premium life insurance policy. This provided Mr. WA with a death benefit as well as providing instant cash value. As the cash value of the policy increased, Mr. WA would also be able to draw a bit more out of his policy - for a short while, though. Even better was the promise of never having to pay taxes on the income he would withdraw from the policy. What a deal! Who wouldn’t want to jump on this opportunity?

There was one hitch that Mr. WA was either not told or of which he was not fully informed. You see, this miraculous "opportunity" was the result of "withdrawing" his cash value in the form of a loan. The basic idea was that the increase in cash value through policy dividends would be enough to cover interest due on the loan each year. Somehow, Mr. WA was unaware that the loan balance would eventually be so high that the policy dividends would not cover the interest due; therefore, Mr. WA would be required to come out-of-pocket with additional interest payments or the policy would be cancelled. So what? All that meant was Mr. WA would no longer owe on the loan, right? He really wasn’t worried - that is until he received a letter telling him he would have approximately $50,000 in income when the policy was canceled.

Here was Mr. WA’s problem - not every withdrawal from an insurance policy is tax-free; only the portion of the surrender value of a policy that represents basis is tax-free. In this sense, life insurance policies are similar to other investments. Most times, if you get more than you invest, expect to pay tax - even if you don’t get the cash. In Mr. WA’s case, he was fine while he still owed the insurance company for a loan against the value of his policy. However, the minute the loan was collected by virtue of the insurance company canceling the debt and in exchange for the value of the policy, Mr. WA automatically picked up taxable income.

So, what could Mr. WA have done to avoid the tax? In reality, there was little Mr. WA could do to avoid ultimately paying tax on policy earnings. While Mr. WA could have paid enough to keep the loan interest current, and thus the policy in force, short of dying, there would eventually be some reckoning for the "free" money Mr. WA used for 20 years.

This deadly life insurance mistake could have been avoided if Mr. WA had understood that he was really entering into a lending relationship with his life insurance as the collateral. Unfortunately, this particular part of the income tax code is considered very little when a policy is surrendered and that lack of understanding can sometimes be deadly.

Let’s look at another deadly mistake. You know that one very useful rule in investing is to use money you don’t expect to need for at least five years. If the investment is part of a qualified retirement plan, or your IRA, you should expect to keep your hands off the funds until you retire, or at least until you are 59 ½. The reason for the former rule is to help you avoid losses by selling at a market down time and the reason for the latter rule is both to help you avoid losses and avoid paying a 10% penalty for early withdrawal of funds.

Did you know that these rules pretty much apply to any annuity you purchase? You might be surprised to learn that along with the advantages of tax deferred annuities, which generally include a death benefit and tax deferred savings, there are a few tiny drawbacks.

First of all, you might as well know that the people who sell annuities to you aren’t in the business for free. In most cases those selling annuities can expect to receive a commission on the sale of the annuity somewhere from 5% to 8%. The issuer of the annuity, which naturally passes the cost on to you, pays the commission. Sometimes the cost is passed on as a decrease in return, but most, if not all annuities, penalize you if you withdraw too much from your annuity during a penalty period. While there is an amount (generally 10% annually) an issuer will allow you to withdraw without penalty, any withdrawals exceeding that amount can carry penalties starting at up to 7%. The longer that you keep the funds in the annuity, the less the penalty percentage will be.

Given the potential penalties for early withdrawals from an annuity, it’s easy to see that you should not invest in an annuity if you reasonably believe you may need the money during the penalty period, but at least the government won’t penalize you for early withdrawals, right? Since we asked the question, you know the government has its hands in your annuity also. In fact, withdrawals from annuities prior to age 59 ½ still have a 10% penalty in the same way premature withdrawals from IRAs and qualified plans carry a penalty. Just imagine, you invest in an annuity, then need the funds immediately - how many times can you lose 7% on your money and pay a 10% penalty on the earnings?

Let’s take a look at another possible scenario that can cost big bucks when purchasing an annuity. Take the case of an 85 year-old man who had approximately $500,000 that was languishing in the stock market. This poor guy would do anything to turn his losses into a guaranteed income, so when a financial planner sold him several annuities, he jumped on the chance. What he was not told was that he would fund the purchase of the annuities with the sale of his portfolio. Given that most of these stocks were held for a very long time and had significant gains, the sale of these securities created a significant tax liability. In fact, after all was said and done, this client had to cash in $60,000 worth of U.S. Savings Bonds to pay the taxes due in the year the annuities were purchased, which cost another $8,000 in state and federal taxes in year two. Talk about a surprised client! Still, the security of knowing exactly what his return would be in the future reduced some of his stress.

Let’s take a look at a deadly mistake many people make in obtaining insurance - lying on the application. There are many reasons one might provide false information on insurance applications - lower premiums, fear of not being issued the insurance, etc. These reasons pale in comparison to the risk of an insurer finding out you lied on an application. Let’s assume you get a $1 million policy to protect your young family if you die. You are a smoker, but answer that you are a non-smoker. Six-months later you contract lung cancer and six-months after that, you die. Upon investigation, the insurance company finds out your lied on the application. All of a sudden, the security you thought your family had is gone- all because of one false statement. The premium savings simply are not worth the risk. Besides, lying on an application constitutes insurance fraud.

There are numerous decisions you make in purchasing annuities and other life insurance related products. This article mentions only a few that could have severe consequences if you miscalculate. Do you know what your risks are? More to the point, do you know what your current and future needs may be? Many questions you ask in ordering your financial planning may seem daunting, but don’t let that stop you. Remember, we are here to help, so don’t hesitate to give us a call if we can be of assistance.