With good reason, safe withdrawal rates and income generation generates a lot of discussion among those advising retirees. A topic that I don’t see getting enough attention is how retirees handle their life insurance.
Many retirees do not need life insurance, or do not think they do, so they drop their policies. Financial planners can be of great value to people as they retire and when they are fully retired by helping them make sensible choices about their life insurance.
Not long ago, when the estate-tax exemption was low, many bought life insurance to offset those taxes. Now that the exemption stands at $5.43 million per person, this need appears to have diminished. Further, many retirees can be forgiven for thinking they have little need for life insurance for income replacement.
Nonetheless, Congress can change the estate tax rules, other taxes still apply, some households need liquidity, and we find some retirees still benefit from maintaining some life insurance for a time, particularly married couples. Many pensions have less than 100 percent survivor payments. Social Security payments to the household drop can drop up to 50 percent when one spouse dies.
Even if these income decreases are not substantial, higher income taxes are paid by widows and widowers when they start filing as singles and their tax brackets compress. When filing a joint return, taxable income above $74,900 is taxed at 25 percent or more (2015). For single filers, the 25 percent bracket starts at just $34,750.
Even if their life insurance policies are not needed, those policies are assets with value and shouldn't be disregarded. In some cases, doing nothing can be costly. For instance, if a policy lapses with a loan balance, the loan becomes taxable income to the owner.
We have seen several cases in which life insurance was sold as a source of tax-free income. The story told is “surrender to basis then switch to loans at zero net cost and no taxes will be due on the payments received.” That is all true as long as the insured dies before the policy lapses. Underfunding, underperformance of the cash value, higher-than-expected costs against the cash value, among other things, can all cause the policy to implode, leaving the owner with a tax bill.
Here’s just eight of many options for dealing with an unneeded or unwanted life insurance policy.
1. Keep the policy. Death is a matter of "when", not “if.” There is an old saying, “No beneficiary ever thought the deceased had too much life insurance.” If the policy is in no danger of lapsing, the heirs should get the death benefit. The obvious drawback to keeping the policy is additional premiums may need to be paid.
2. Surrender for the net cash value. This is a popular choice for those who cannot or do not want to pay premiums or repay loans to keep the policy in force. Of course, cashing out means that when “when” comes around, there will be no death benefit.
A lot of retirees get the math wrong on this because they do not factor in taxes. While death proceeds from life insurance are usually income tax free, ordinary income rates apply to amounts received above the basis in the policy. This tax bill can surprise the unwary and be significant.
3. Let it lapse. In some cases, the cash value is not enough to keep a loan-free policy in force for long if the basis in the policy is low and the owner does not wish to make additional payments. Instead of cashing out and incurring the taxable income, some in this situation will simply let the remaining cash value fund the policy for as long as it can last on its own. If the insured dies before the policy lapses, the beneficiaries will receive the tax-free death benefit.
Advisors need to be careful with this approach as many policies have automatic premium loan provisions that will borrow against the cash value to cover premium payments, potentially creating the taxable loan distribution situation described earlier.
4. Employ a 1035 exchange. Cash values in a life insurance policy can be exchanged, tax-free, to another life insurance policy or an annuity contract. The exchange to a new life insurance contract can be an attractive option for people who own an expensive or otherwise poorly designed policy, if they are healthy enough to get attractive rates when underwritten.
5. Sell it. Life insurance is an asset and can be sold. There are many companies that will facilitate the purchase of a policy and the client will get more money than if they simply surrendered their policy. Tax treatment is generally similar to cashing out with taxable amounts subject to ordinary income tax rates, not capital gain rates.
The buyer wants a return and has to keep the policy alive long enough to garner an acceptable return. Generally, the older the insured or the worse the insured's health, the more the owner can get for the policy because the new owner expects to get the death benefit sooner, boosting the return on the buy.
Keep in mind that if one is that unhealthy, it can be better to take other steps to keep the policy in force so the family can get the full tax free death benefit rather than a smaller, probably taxable, amount of sale proceeds. Some families can pull this off.
One thing to look out for when discussing selling a policy is many people find the idea disturbing because they feel the buyer will be wishing ill upon the insured. Regulators have some concerns about this dynamic as well. Nonetheless, a sale can be a legitimate option.
6. Get some help. This is one of those other steps to which I just referred above. We have seen family members fund a policy because an unhealthy insured was unable to do so. The death benefit more than makes up for the outlays. This is not done as an “investment” by any means. We usually see it as a way to make sure mom gets a needed death benefit from a policy that would be a burden to maintain. Be sure to verify the beneficiary designations are correct and be aware that the creepy factor can be even more problematic when the emotions that go along with caring for an ailing family member are added to the mix.
7. Donate it. Like other assets, a life insurance policy can be donated to a charity and a charitable tax deduction received. Not all charities are equipped to handle all policies and one could argue other assets would make a better donation but it is a viable option for some.
8. Modify it. Many policies allow modifications like reducing the death benefit. Sometimes such a change will allow the policy to stay in force much longer or reduce the premiums needed.
Each of these options come with their own twists and turns. How does one decide what to do?
The starting point is to get all the needed information to assess the "health" of the policy. We would request an "in force ledger statement" and a copy of the policy and go from there.
Life insurance is a contract with specific and often complex provisions that dictate how the policy works, what the costs are, how the costs can change, and what and how modifications can be made by the owner or the insurance company.
You don’t have to sell insurance to be of service to clients with respect to their insurance policies. First, it is acceptable to insurance regulators for financial planners to give generalized advice about life insurance options or the need for life insurance. They will get more particular if you dive into specifics about an insurance contract when not licensed to do so.
Here in Florida, to give specific advice about a life insurance contract, you can either become licensed to sell life insurance as an agent or, as we have done and some other states allow, have a person on staff obtain and maintain an “unaffiliated” agent’s license. It is somewhat analogous to choosing to be a registered representative of a broker-dealer vs. an investment advisory rep when working with securities.
Risk management is a cornerstone of financial planning. Changing life insurance needs should not be ignored. Sifting through this can be very complex but that is why doing so has value. We often find it is well worth the trouble and appreciated by clients.
Dan Moisand, CFP, has been featured as one of America’s top independent financial advisors by Financial Planning, Financial Advisor, Investment Advisor, Investment News, Journal of Financial Planning, Accounting Today, Research, Wealth Manager, and Worth magazines. He practices in Melbourne, Fla. You can reach him at [email protected].