You are preparing for retirement and thinking about your expenses. One expense you’d rather not have is the premium you pay for the life insurance you bought decades ago. The question is: Do you only have two choices, pay the premiums or cancel your coverage? The answer is no, you usually have other alternatives.
Start evaluating your options by first determining whether your policy is term life insurance or some type of permanent insurance with cash values.
Term life insurance is usually the cheapest coverage, but it works like rent. If you “rented” the insurance, you leave with no equity. So if you reach the end of the contract term – for example 20 years – you lose your insurance cover. However, you may still have some options. Some term policies allow you to extend your coverage. You can keep your insurance, just at a higher premium. In general, the cost increase is so high that it’s a deal killer. If you need the coverage, however, it may be worth it.
Term insurance policies often have conversion rights, which means you can convert your term insurance into a permanent plan. The good news is that this will continue your death protection for the rest of your life, but the bad news is that you will be paying a much higher ongoing premium. While this might sound like a non-starter when you’re about to retire, it can be a good idea if your life expectancy has been cut short due to illness. The Conversion Privilege also allows you to convert your soon-to-expire policy to a perpetual policy without having to prove your insurability – no exam or blood work.
If your spouse or children need death coverage while you’re away, it’s worth considering converting your liability insurance. If you can’t afford the higher premiums, they may be able to pay for the coverage.
The so-called permanent life insurance is analogous to owning vs. renting. You build up equity in your insurance in the form of cash values. The temptation in retirement is to cancel the policy and collect the residual value of the policy. In many cases, however, this may be the least financially sound approach.
Let’s take an example. You paid $2,000 a year for a $250,000 life insurance policy for twenty years. You have $40,000 invested in the policy, but you also have $60,000 in cash to show for your expenses. If you abandon the policy, you get $60,000 from the insurance company, but the IRS wants a share — in the form of ordinary income tax, not capital gains — of the $20,000 gain versus your $40,000 expense.
4 ways include not having to pay the premiums yourself
Maybe there are better approaches. Below are four popular options for continuing your insurance coverage while still paying ongoing premiums:
Stop paying premiums
If you have accumulated excess cash value in your policy, this equity represents an asset that you can use to continue your coverage. In its simplest form, cash value can pay the premium. Using the example above, you can instruct the insurance company to withdraw or lend the premiums for your policy from your $60,000 cash value. This will reduce your death benefit due to the policy loans and accrued interest, but your insurance coverage will remain.
Depending on the policy, you may have other ways to use your cash value. For example, you could use cash value to buy extended-term coverage. With this approach, instead of telling the insurer to deduct the premium from your cash values, you can ask them how long they will continue your full $250,000 death benefit without paying any more premiums.
Let’s say they calculate that your coverage lasts five years and three months. This can get you close to the date you want to apply for Social Security and may be a good time to let the policy expire.
Another approach would be to ask the insurer for a reduced non-contributory policy. This is where the insurer can tell you that you’re entitled to $122,400 of coverage for the rest of your life — no premiums, no cash value, but a lifetime guarantee.
Sell your policy
Your life insurance has been calculated based on your life expectancy at the time you applied for the policy. But now, a health condition can shorten expected life expectancy. That means, callous as it sounds, someone might be willing to pay good money for your policy. This option is commonly referred to as Life Settlement and there are a number of companies that will assess your life expectancy and make an offer to purchase your policy. A life settlement offer always results in more money than the cash surrender value of the policy. You sell your policy and they collect your death benefit when you die.
If you’re interested in this idea, heed two caveats:
- First, the life insurance industry is comparatively new and still something of the wild, wild west of insurance transactions. It is best to do your research and work with a reliable agent and company.
- Second, you should be aware of the tax ramifications before completing the sale. Depending on the transaction, the sale may be tax free, partially taxable as ordinary income and/or partially taxable as capital gains. What you have after taxes is the key question.
Donate your policy
When you no longer need the death benefit from your policy and don’t want to pay premiums, consider donating the policy to your favorite charity. You get a current tax deduction for the value of the policy. When making a donation, ask if the charity plans to continue paying premiums (so the full death benefit can be collected) or return the policy for its cash value. This may influence your decision on which charity you choose to work with.
For example, if you have a $1 million policy with only $30,000 in cash value, you might decide to donate the policy to a national charity that can afford to pay the ongoing premiums and wait until you receive the death benefit. Also, contact the insurance company for an evaluation of the policy. You may be able to deduct more than just the cash value of the policy for tax purposes.
Let your IRA pay the premiums
You may be thinking, “What’s the difference between me paying the premium and my IRA paying the premium?” Isn’t it still cash?” The better question is, do you intend to leave a legacy to your heirs when you die? Life insurance has the benefit of being a known, income tax-free payment to beneficiaries, regardless of stock market performance at the time of your death. If you’re planning on arranging wealth when you die, that life insurance policy you’ve owned all these years might be the perfect asset.
So instead of tapping into other sources of income, consider paying the annual premium through partial withdrawals from your IRAs. Although you pay taxes on those withdrawals, you’re effectively spreading your taxes over your remaining lifetime. This can help with your strategy for filing Social Security contributions, controlling the IRMAA penalty associated with your Medicare premiums, and capping the minimum required distributions (RMDs) you receive at age 72.
Work with your financial advisor to determine the best approach, including the option of paying a portion of the premiums with a Roth IRA.
Life insurance is different from most forms of insurance. With fire insurance, there may never be a claim. In contrast, if you hold on to life insurance long enough, there is will be a death. So as you approach retirement, think carefully about what you want to do with your own life insurance. There are many other ways to benefit from this than just lapse your policy.
Co-Director, Retirement Income Center, The American College of Financial Services
Steve Parrish, JD, RICP®, CLU®, ChFC®, RHU®, AEP®, is Adjunct Professor of Advanced Planning and Co-Director of the Retirement Income Center at the American College of Financial Services. His career includes years as a financial advisor, attorney and executive of a financial services firm. He focuses on legal, estate planning, tax and financial strategies that can contribute to a successful retirement.