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.