What to do with an old life insurance policy
Many people obtain life insurance during their working years to protect their love ones against the risk that their premature death could eliminate years of financial support for their family. A large death benefit could be used to pay off a mortgage and continue to fund a family’s day-to-day living expenses for years, as well as provide funds for college expenses and even retirement funds for a surviving spouse/partner. For most, this risk lasts until children are grown and they buy insurance that has a “term” that coincides with the ages that they expect their children to become financially independent.
An alternative to term insurance is “permanent insurance”, which is designed to provide a death benefit that lasts as long as the insured’s life expectancy. There are other risks that make “permanent” insurance suitable, such as ensuring that a spouse or disabled family member has a pool of financial resources after the death of a parent/breadwinner. Using the death benefit from a permanent life insurance policy to replace wealth that may be lost to estate transfer or other income taxes may also be appropriate for those with significant wealth.
Beyond this fairly straightforward context, things get complicated. In my experience, most people who own permanent life insurance contracts did not seek them out. It’s more likely that these policies were “sold” to the owner rather than being purchased, which reflects the nature of the life insurance distribution system.
Life insurance contracts are complicated by their terms and features and the various insurance companies who sell them. As a result, it’s difficult for individual consumers to shop and compare and a life insurance agent typically ends up being the facilitator in choosing your life insurance. What you end up with depends on the options that the agent makes available to you (which further depend on the carriers they represent and any specific contracts they may be financially induced to favor, as well as their own expertise and personal biases).
Whole life insurance contracts are a type of permanent life insurance that we see folks owning long beyond their need for the death benefit ends. Whole life contracts provide a death benefit that lasts for your lifetime, along with a “cash value” that can accumulate over time as a kind of a forced savings mechanism.
An appealing part of the sales pitch for whole life insurance is that your ability to borrow against the cash value later in life as a tax-free way to supplement your income in retirement. As appealing as this may seem at the time of purchase, I have never actually seen someone borrow against their whole life insurance policy to supplement their income in retirement. Part of this is because folks typically don’t want to start taking on debt in retirement. Hopefully, a more important reason is because they come to learn that it can be risky. A policy that “lapses” with a loan outstanding causes the loan itself to become taxable income and you can potentially leave your heirs with only a tax bill to be paid from your estate and no death benefit or cash value to fund it.
We routinely see folks with older whole life insurance contracts that have accumulated cash value and that they don’t necessarily need anymore. And because they’ve made a significant investment in them by paying premiums for many years, they are understandably reluctant to part with them.
If you or someone you know is in a similar situation, then the following are some options to consider, with the caveat that everyone’s situation and the particular economics of any contracts they own are different.
- Keep the policy
If you can afford the premiums, or if premiums are longer required because you’ve owned the contract for a long time and the annual cash value increases and dividends now exceed the require premiums, then you can always choose to keep your contract and leave the death benefit to whomever you designate as a beneficiary.
Knowing that you have the death benefit to leave in place, it may free up other “legacy” assets for you to spend on yourself or even invest more aggressively for your heirs. Or if you have no heirs, then you could always name a charity as the beneficiary (this may work well for smaller policies that you don’t need, but where no further premium payments are required).
Please know that you need to check with the insurance company to see if you policy can be supported without further premiums required. And also remember that policy beneficiaries receive only the death benefit alone, not the death benefit and the cash value. When the insurance company pays out the death benefit, it keeps the cash value, which effectively reduces the insurance company’s risk as it is only on the hook for the difference between the policy’s cash value and the death benefit.
- Surrender Your Policy for its Cash Value
Once seen as the “only” option if a policy was no longer wanted, needed, or affordable, many policyholders still take this option simply because they do not understand the other options available to them. By surrendering the policy, you can free up the after-tax cash value to be used for whatever you need or want, but it’s not the only option and there are income tax considerations to be aware of.
- Reduced Paid-Up Life Insurance
Rather than surrendering your whole life policy, you can use the cash value to convert it to a paid-up policy with a smaller death benefit. The benefit of this is that you would no longer have any premium payments to make, which may be helpful in retirement while still allowing you to leave something to designated beneficiaries. You need to contact the insurance company in order to determine the reduced paid-up amount.
- Sell Your Life Insurance Policy for Cash
One way to get cash when you need it is to sell your policy and the rights to your death benefit via a “life settlement” or a “viatical settlement”. The life settlement market has grown rapidly in recent decades, to the point where you’ve likely seen ads on TV for these. People who are very elderly and/or suffering from serious health issues, both of which increase the likelihood that there will be willing buyers, may find this to be a suitable option. And it’s possible to get more than the cash value of the contract this way depending on the specific situation.
- Withdraw Your Cash Value
If you are withdrawing cash below your cost “basis” (the amount you’ve paid into your policy), then you can withdraw part (or even all) of your cash value without penalties or taxes. You also don’t have to pay back what you withdraw, as it was your money to start with. This might be a preferable option to a home equity loan or borrowing from your 401(k) or IRA, as there are no penalties, taxes, or qualifying procedures. However, your cash value stops growing if you withdraw it, so you might prefer the next option if you’re considering how to use life insurance to access cash.
- Borrow Against the Cash Value on Whole Insurance
Typically, people borrow against their cash value by going directly to the life insurance company for the loan. Since the cash value is collateral and the company has that in their possession, this is also fast and hassle-free (no credit checks, pay stubs, or approval process). If the rates at your bank are better, you might be able to borrow from your bank instead, still using your cash value as collateral.
People and even financial advisors often talk about “borrowing your cash value.” But that is a misleading, inaccurate phrase. You don’t actually borrow the cash value itself (nor do you pay back interest to yourself, in spite of what you might have been told). If you’re borrowing from your insurance company, you’re leveraging your cash value by borrowing against it. And as mentioned above, there are significant risks to this option and we caution against doing this for any extended period of time.
- Receive an Accelerated Death Benefit
Whether or not you have this option available to you will depend on what options and riders you chose when you purchased your policy. If you do, then you may be able to receive a portion of the face value of the policy (the total value including the death benefit) by proving that you have a qualifying diagnosis or condition, such as a chronic or terminal illness.
- Annuitize Your Policy
In contrast to borrowing against your policy, you have the ability to exchange the cash value of your life insurance contract for a life annuity. You would have to select a payout option, such as your life expectancy or 10 or 20 years, or even you life expectancy with any unpaid amount directed beneficiaries. And you would forego the death benefit and instead receive a specified amount of income each month during the payout time frame selected.
- Take Your Dividends Out in Cash
If you are just looking for “a little extra” cash to make the difference between surviving and thriving, then you need to know that you have dividend “options”. Typically, your dividend option is set to “purchase paid-up additions” by the agent who sold you the policy (which increases the policy’s death benefit and cash value over time). But as the owner, you can either take the dividends out as cash, direct the dividends to simply accumulate in the cash value of the contract, or use the dividends to reduce your premium payments. Dividends are effectively a return of premium (more $$ are put into the contract that is required for the death benefit purchased) so any dividends directed to you in cash are received tax-free up to your cost basis in the contract.
- Exchange the Cash Value for Another Insurance Policy
As we wrote last week in “Life Insurance is not a Buy and Hold Asset”, it may be possible to exchange the accumulated cash value of a whole life policy to extend the coverage of a whole life policy in danger of lapsing, to reduce or even eliminate further premiums on a different permanent insurance policy with the same death benefit amount, or even to increase the death benefit a different permanent insurance policy with the same or lower premiums required. The specifics of these will depend on your needs, the economics of your current policy and your insurability.
- Exchange the cash value for Hybrid Long-Term-Care (LTC) Insurance policy
One of my favorite options, for folks whose needs have changed and no longer need their whole life policy death benefit, is to exchange the policy’s cash value for a hybrid LTC insurance policy. This assumes that you don’t have LTC insurance already (or have only a small amount that could be supplemented).
Traditional long term care insurance requires annual premiums that can increase over time like any other health insurance. And a common objection to traditional long-term-care insurance is that it works like any other insurance you own (homeowners’, auto, medical) where if “you don’t use it, then you lose it”.
In contrast, a hybrid LTC insurance policy provides long-term-care benefits along with a death benefit and a cash value. So, if you don’t use it, you heirs still receive something through either the death benefit or by surrendering it for the cash value if needed. And, unlike paying annual premiums for many years for traditional long term care insurance that can increase, if you exchange the cash value from your whole life contract as a single premium payment into a hybrid contract, then all of the benefits in the hybrid contract a guaranteed.
Hybrid contracts are designed to maximize the long-term-care benefits and not the death benefit or cash value. The long-term-care benefits compare favorably to a traditional long-term-care policy for similar premiums paid. As opposed to surrendering your whole life contract, and potentially paying income taxes on the difference between its cash value and your cost basis, exchanging the cash value to a hybrid LTC insurance contract is income tax-free and any qualified long-term-care benefits from the hybrid contract are income tax-free.
Using the cash value from an old whole life policy to fund a hybrid LTC insurance policy can be a great option for someone whose needs have evolved from needing to take care of their family to the point where their family is ultimately going to be responsible for taking care of them.
If all of the above seems straightforward, but trying to decide between or among these options seems overwhelming, then you’re not alone. Permanent life insurance contracts are complicated, but understanding what your needs are and whether or not what you own still serves its originally intended purpose doesn’t have to be. Have a conversation with your ACM Wealth Advisor if you have questions. He or she has the benefit of our collective experience and likely has seen a situation similar yours more than once and, as a result, is positioned to help you evaluate what you own and the options you have.
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