Most people buy large life insurance policies when they are just starting out, when they are first getting married or having children. The amount of life insurance you need when you’re just starting your career is usually much greater than the need when you are nearing the end of your career – you don’t need to guard against the potential devastating loss of 30 years’ worth of income if the breadwinner in your family should die early.
Indeed, once you are nearing retirement, the kids are grown and no longer dependent on your income, you may not need or want the life insurance policy so much anymore. Instead, you may be tempted to keep premiums in your pocket, and get as much cash as you can for the policy.
So what are your options?
Well, you have four of them – called non-forfeiture options.
If you have cash value sitting in a permanent life insurance policy, you can simply “surrender” the policy. The insurance company will then send you the cash surrender value that you have built up in the policy, cancel the policy and call it even.
The IRS, however, may want to have a word with you. If your cash surrender value exceeds the amount of money you put in, you will have to pay taxes on any gains. And since IRAs can’t hold life insurance policies, there’s no deferring that tax liability.
Meanwhile, you lose the benefit of years of potentially tax-free compounding within the insurance policy. This may be worth it if you have a universal life policy with a declining cash value because your premiums are coming out faster than your cash value is appreciating: Such policies will eventually lapse, when cash value reaches zero. But for whole life policies it may not be the best option.
Swap it for an annuity
Section 1035 of the Internal Revenue Code allows you to exchange your life insurance policy for an annuity, tax-free. With an annuity, you will get tax-deferred growth on your money. And when you begin drawing down the annuity, you will only have to pay taxes on the growth since you executed the exchange. You also won’t have any ongoing life insurance premiums to worry about.
An annuity is simply a contract with an insurance company guaranteeing you a stream of income in the future, in exchange for a lump sum of cash now.
Annuities do have fees and expenses of their own – typically between 1 percent and 4 percent of assets per year, but they do come with some guarantees, which differ with the annuity contract. You can tailor them to generate a fixed, guaranteed rate of return (fixed annuities) or use variable annuities, assuming some risk in the hopes of generating a higher return. You can even elect an option that pays you, or you and a beneficiary, a guaranteed income for life.
Before you swap your insurance policy for an annuity, be sure you understand the surrender charges on the annuity policy. Typically, you won’t pay a commission out of your own pocket. But if you don’t hold the annuity a certain number of years, you will typically have to forfeit a percentage of your annuity back to the insurance company that sold it to you.
There’s also a 10 percent penalty for withdrawals from annuities prior to age 59 and a half, in most instances.
Reduced Paid Up Insurance
If you can use a small, permanent death benefit, you can elect to take a small death benefit, fully paid-up, with no more premiums due. This may be appropriate to help offset possible estate taxes, or simply to provide cash to help bury the insured. There are no taxes on the transaction if you elect this option, and the death benefit, of course, is generally tax-free to the beneficiary as well.
If you change your mind, you may be able to reinstate your policy, provided you elect to do so within a certain number of years.
Extended Term Insurance
Another option is to trade your higher premium permanent policy for a term policy. Your cash value would go to paying the lower premiums on a term policy that would last much longer than your permanent policy if you stopped paying premiums. This might be suitable for you if your policy is likely to lapse, you are tight on cash, but your family will still need a substantial death benefit for a while longer.
Be wary of agents offering to buy your insurance policy from you as an investment. These are called “Stranger-Owned Life Insurance, or STOLI policies. Some of these are legitimate, but the practice is illegal in some jurisdictions. If left uncontrolled, the practice may give someone with no connection or bond of affection to you a financial interest in your death. Contact your agent before entering into any arrangement to sell your death benefit to a third party.