American Greed

The Greed Report: Avoid these common life insurance traps

Nanette Johnston was the very definition of a femme fatale. Beauty. Allure. An uncanny knack for separating a man from his sense of reason, his money, perhaps ultimately his life.

"This is not only a gold digger, it's a gold digger with a black heart," said Matt Murphy, deputy district attorney in Orange County, California.

The 1993 murder of Johnston's lover — California businessman Bill McLaughlin — nearly went unsolved, confounding police and prosecutors for more than a decade. Cracking the case, as recounted in the season premiere of CNBC's "American Greed," took some sharp detective work by Murphy and his team. They uncovered a key piece of evidence: a $1 million life insurance policy taken out months before McLaughlin's death. The sole beneficiary: Johnson, who began serving a life sentence for murder in 2012.

Murder for insurance money is one of the oldest tricks in the playbook of the truly greedy. It is also the stuff of books and movies, like the 1944 classic "Double Indemnity." Fortunately, few of us need to consider murder when structuring our life insurance. But the process is riddled with pitfalls and requires careful thought.


Couple doing paperwork
Elena Leonova | Getty Images

Let's talk insurance

"Life insurance is a difficult thing to talk about with somebody, because you're talking about something that's going to protect those you care about when you're not here," said Keith Friedman, founder of FBO Strategies, an estate-planning firm based in Stamford, Connecticut. "So you're talking about death. But I would say if you love somebody or somebody else loves you, you should most likely have life insurance."

The different types of life insurance products vary widely, but all provide for a beneficiary — the person or entity that receives the proceeds when you die.

"The first choice you want to make is who you need to protect first," Friedman said. "Ninety percent of the time, it's about your spouse, and then your children."

But even that is more complicated than it appears. All too often, Friedman says, people name minor children as beneficiaries. If you die, they are entitled to the proceeds when they turn 18.

"I don't know about everyone else's children, I love my children, they're great children, but receiving maybe several million dollars at the moment they turn 18 might not be the best decision," Friedman said.

A better option is to set up a trust in your child's name and make it the beneficiary. That gives you some control — and lets you save your children from costly mistakes — even after you are gone.

"You can say that the children or the beneficiaries get money for certain things, like to pay for college, or maybe to buy a home or start a business. And then they get principal of the money over time," Friedman said.

Unholy triumvirate

A trust can also address the tax implications of a life insurance payout to your loved ones. While life insurance proceeds are free from federal income taxes, they can be counted as part of your estate and subject to estate tax if you owned the insurance policy. If you have a large estate or a large policy, leaving those proceeds to a trust keeps them outside your estate and out of the reach of the taxman.

But the estate tax is just one of the potential tax traps.

Experts warn of what they call the "unholy triumvirate" in life insurance: the policy owner, the person being insured and the beneficiary.

"Usually you can have the insured and the owner be the same person, and the beneficiary is the second person. Then you've created a tax-free environment," Friedman said. "However, if all three of those people are different people or different entities, you have created a taxable income gift to your heirs or to whoever the beneficiary is, because it's deemed as a gift through the way the tax law reads."

For example, say you take out a life insurance policy on your mother, naming your child as the beneficiary. The payout from that policy would be considered taxable income to your child.

"By properly choosing your beneficiaries, your owner and your owners correctly, you can easily avoid it," Friedman said.

Where there's a will

A common misconception is that you can use your will to dictate where the life insurance proceeds will go, but Friedman says that is not the case.

"A life insurance policy exists outside your will. It's a contract with the life insurance company. So the life insurance company actually doesn't care what the will says," Friedman said.

The result can lead to unnecessary stress and even legal disputes among your beneficiaries, and ultimately, your assets not going where you wanted them to go.

Experts say life insurance should be part of a broader estate plan, and an effective way to equalize how your assets are distributed. For example, if you want to leave property to one of your children, you can see to it that another child gets an equivalent amount in insurance money.

Friedman says it is important to get your loved ones involved in the conversation so that there is no misunderstanding and no room for arguments later on.

"The only people who make money in an argument is the lawyers," he said.

'Til death do us part

The most common beneficiary is a spouse, and in a handful of states, that decision is essentially made for you as a default.

Nine states — Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin — are "community property states," where any property acquired during a marriage is considered to be owned by both spouses. In a community property state, any arrangement in which your spouse is not the primary beneficiary will likely require a written acknowledgement by both spouses.

But whether you live in such a state or not, give at least some thought before naming a spouse or fiance in a life insurance policy, and review your designations from time to time.

"Every time something changes in your life, you should always review it," Friedman said.

That can be a new job, a new child, a new home, anything that changes your financial situation. Regardless, experts say you should review your life insurance and your overall estate plan at least every five years.

And when it comes to your spouse or significant other, realize that as rosy as things might seem now, relationships can change.

"If your personal relationship with someone does turn bad, whether that's through a divorce, a called-off wedding, a business relationship, one of the first things you're going to want to do is actually check your life insurance policies," Friedman said.

If it is any solace, real life "Double Indemnity"-style scenarios are rare, and almost impossible to get away with.

"If you commit a crime to get the proceeds of life insurance, you're not going to get the proceeds," Friedman said.

Even Johnson finally landed in prison, though in her case the long arm of the law needed some extra reach.

See how authorities finally got their woman on the All-New Season Premiere of "American Greed — Deadly Gold Digger" — Monday, Jan. 23 10P ET/PT only on CNBC.