One of the common dilemmas I see retirees and near retirees face is what to do with life insurance policies they no longer want or need.

Some retirees still find a need for life insurance. Common reasons include a reduced survivor benefit from a pension plan, the decrease to just one Social Security benefit when a spouse dies and higher income taxes paid by widows and widowers.

Nonetheless, one definition of retirement is it is the time you permanently leave the workforce so it follows that many retirees have little need for life insurance for income replacement purposes. In addition, with the estate tax exemption now up to $5.49 million per person, the use of insurance to offset these taxes is less common.

Unfortunately, many clients view their policies as a puzzle or even a nuisance. Fact is, those policies are assets with value and shouldn’t be disregarded. In some cases, like a policy with a loan, doing nothing can be costly.

So what should a retiree do with their life insurance? Of course, what to do depends on many factors but in my experience retired clients have taken one of the following eight options.

1. Keep it—Everyone dies eventually. If the policy is in no danger of lapsing, heirs should get the death benefit.

2. Surrender it—With the premiums stopped, cash received in excess of basis is taxed at ordinary income rates, not the lower capital gains rates. No death benefit is left for heirs.

3. Let it ride—Stop premium payments and let the remaining cash value fund the policy for as long as it can last on its own.

4. Sell it—Life insurance is an asset and can be sold. The older the insured or the worse the insured’s health, the more the policy will sell for.

5. Donate it—Like other assets, a life insurance policy can be donated to a charity for a charitable tax deduction.

6. Get some help—In some cases, we have seen family members fund a policy because an unhealthy insured could not afford to do so.

7. Modify it—Many policies allow modifications that can make the structure of the policy more appealing.

8. Exchange it—Cash values in a life insurance policy can be exchanged, tax-free, to a new life insurance policy or an annuity contract.

Each of these options comes with its own twists and turns, but I want to focus on exchanges today because this option looks different today than it did only a few years ago.

Traditionally, exchanging under Section 1035 was done to get out of an expensive or otherwise poorly designed policy and into a better policy when a person still wanted life insurance. Today, another situation warrants consideration of an exchange—asset-based long-term care products.

I am not a big fan of asset-based LTC life plans. In general, the life and long-term care coverage has opaque and mediocre pricing. However, there are situations where other benefits may overcome this. 

Sometimes, we encounter people who have cash value life insurance they don’t necessarily need, premium payments they definitely don’t want, but who would get hit with a lot of ordinary income upon surrender.

“Kim” would be an example. She is in her early 60’s and has left the workforce permanently. Kim has a variable universal life insurance policy with $100,000 cash surrender value and a basis of $30,000. She sees little need for the policy and does not want to put more money into it. 

Her husband “Tim” makes a good income in the family business but is only working until the business can be sold. A deal is close at hand that will involve installments over ten years so they expect to stay in a high tax bracket for years.

They are concerned about long-term health-care expenses but are also concerned about getting LTC insurance because they have read about some big companies leaving the business and some of their friends have seen substantial premium increases.

Looking at our options above, we get this:

1. Keep it—Unappealing.

2. Surrender it—Premiums stop but $70,000 in ordinary income is not attractive. 

3. Let it ride—She could stop premiums and if Kim gets hit by a bus before it lapses, there is a death benefit but the policy probably won’t stay in force to her life expectancy.

4. Sell it—Kim is young and healthy and not likely to net much. Taxation is as unattractive as it is for a surrender.

5. Donate it—Not attractive to Kim and Tim.

6. Get some help—Not applicable for Kim and Tim

7. Modify it—They could drop the death benefit so that they could stop premium payments and increase the odds of the policy paying upon death. They would still be getting an unneeded death benefit, but the death benefit wipes out the potential ordinary income taxation issue from prior options. 

8. Exchange it—An exchange can produce a similar result to modifying. Often premiums are not needed to keep the new policy in force long enough to pay a tax free death benefit. New underwriting is needed and initial policy costs are incurred but there may be better underlying costs or cash value investment options. As with modification, death erases the taxation on the cash value.

If an exchange is possible, clients in a similar situation to Kim should consider an asset-based LTC product. Doing so adds an additional trigger to using the cash value tax free.

In 1996, the Health Insurance Portability and Accountability Act (HIPAA) provided that if a policy meets certain triggering events for payments of benefits, those benefits are received tax free. See IRC Section 7702B. HIPAA also spawned “combination contracts”, aka hybrid or asset-based LTC policies.

So, if Kim’s policy can be exchanged into a hybrid policy that will last without premium payments, the proverbial bus will result in a tax-free check for Tim just as it could after a modification or a traditional exchange. However, with the asset-based LTC policy, she also creates the possibility of drawing tax- free checks to cover her long-term care needs. 

A similar possibility to get otherwise taxable income on a tax-free basis exists with annuity contracts. The Pension Protection Act of 2006 extended the tax-free treatment of life/LTC combo contracts to deferred annuity/LTC combinations. A client with a lot of growth in a deferred annuity provides a potential pool of tax free dollars for care by exchanging into an asset based annuity product. 

Think about that. How often do you run into a client that is, say, already dealing with required minimum distributions and is reticent to take additional income taxed at ordinary rates from a deferred annuity?

If care is a concern, an asset-based LTC might have appeal. In fact, the underwriting is so different from life insurance or standalone LTC products, even some people for whom care is likely to be needed soon can get into a hybrid annuity.

Now, I would be remiss if I didn’t point out that I am omitting a lot of details. There are not a lot of products to choose from. I haven’t said anything about the ins and outs of 1035 exchanges or partial exchanges. Policies with loans complicate things and the tax treatment is not straight forward.

This column isn’t meant to be technical. I bring these hybrid products up simply because I don’t want financial planners who, like me, have been less than wowed by asset-based LTC products to dismiss them out of hand. In the right circumstances, these products can be useful.

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 www.moisandfitzgerald.com.