Many baby boomers have been paying for one or more life insurance policies for most of their adult lives. As children grow up and move out, the need for life insurance diminishes. Even an otherwise dependent spouse may not need as much or any life insurance protection. Instead, accumulated retirement assets, disability insurance, long term care insurance, and Social Security benefits can be counted on to replace income lost from an unexpected death.
So what strategies should baby boomers consider in working with existing life insurance policies and future life insurance needs? These are the strategies I am looking at:
Allow Term Insurance Policies to Expire
Use Policy Dividends to Pay Premiums
We purchased hybrid term/whole life insurance policies on my wife and I when we were young and about to start our family. We also bought these policies for each of our sons when they were born. This probably was not the ideal financial planning strategy but we did it as a means of forced savings combined with death benefits. We still own all of the policies. A few years ago, the dividends paid by these policies had grown to the point where they could be used to pay almost all of the premiums on the policies, so we instructed the insurance company to pay the premiums that way. The only premiums we pay now are on term policies, yet the cash value on the whole life policies continues to grow.
Allow Policy Cash Value to Grow Tax Free
One of the tax-planning benefits of a whole life insurance policy is that the cash value grows tax free. The IRS considers policy dividends (which create the cash value) to be a return of the premiums you paid over the years. Only if the total dividends paid exceed the premiums paid are you taxed, and then only on the difference. The IRS does not require you to make that determination or pay any tax owed until the policy is surrendered. I am almost certain that our cash value now substantially exceeds premiums paid. For that reason, even though I plan on surrendering the policies at some point to get access to the cash value, I don’t want to do it unless it makes good tax sense. What I will probably do is wait until I retire, then decide if and when I need to supplement other retirement income by liquidating other assets. If I have a need to do that without adding to our tax burden, I will consider surrendering one or more of the whole life policies. My tax rate should be lower at that time, although I am not certain of that.
Borrow Against the Cash Value
I may decide at some point that I want to keep at least one of the whole life policies in force for the death benefit. On the other hand, I would prefer not to die with cash value in the policy because I will have lost it. So what I might consider doing is borrowing against the cash value and probably not pay back what I borrowed. You can usually do that as long as what you borrow plus interest does not exceed the cash remaining in the policy. One of the important things you need to be careful about if you decide to borrow against life insurance cash value is phantom income. In other words, if your loan balance equals your cash value, then you decide to cancel the policy, you will be taxed on the amount by which your loan proceeds exceeded the premiums you paid. The problem with that scenario is that there won’t be any cash in the policy to pay the taxes. You could have a large tax bill (at ordinary income tax rates) and no way to pay it. The way to prevent that from happening is to keep paying on the policy until you die. That may not be the best overall strategy for you, so think carefully before starting a program of borrowing your life insurance cash value.
Surrender and Convert to a Life Annuity
I don’t know yet whether this is possible, but I can see some advantage to converting the cash value in our existing whole life policies into a single premium, fixed annuity, paying lifetime income. If that could be done without creating a taxable event on surrender, that would be ideal. This is something I need to investigate.
These are the primary strategies I have been thinking about. One of my good friends is an insurance professional, so I plan on speaking to him about other options, including the annuity option and possibly incorporating life insurance into our estate plan. That is a discussion for another day.
Image credit: Vjeran Lisjak