What to do with a life insurance policy at retirement

By: Dennis Ho

Published in May 2020 by The HumbleDollar (original article may be viewed here).

For most people, life insurance is purchased to protect their income in the event of an unexpected death. If you’re 35 years old, you potentially have 30 or more years of future earnings that your family would lose if you passed away, so having life insurance during these working years makes sense. But what happens once you reach retirement? Before canceling your policy, it’s important to assess your situation, because keeping the coverage might be the better choice.

If you have a term life insurance policy, the key question you should ask at retirement is, “Will anyone suffer financially if I pass away today or in the future?” Even though you’re no longer working full-time, there could be people still financially dependent on you.

For example, earnings from a part-time job or your Social Security check could be an important source of income for your family. Alternatively, you might be a caregiver for aging parents who would be hard-pressed to pay for care if you weren’t around. In these situations, the rationale for life insurance — protecting those you care about from financial ruin if you pass away — still holds and keeping the policy makes sense. Depending on your situation, you might even consider adding to or extending your coverage.

On the other hand, if you can honestly answer “no” to the above question, then you can likely terminate your term life policy and put the premium dollars toward retirement instead. There’s generally no tax impact when cancelling a term policy and the process is as simple as calling your insurance company.

If you have a cash value policy — such as whole life, universal life or variable universal life — the analysis is more complicated. Because cash-value policies are more than just life insurance, the first thing to consider is why you purchased the policy in the first place. Was it for the life insurance protection or was it as an investment? Is the policy part of a larger tax or estate planning strategy? Once you understand the role this policy plays in your financial life, you can evaluate whether to keep it — by using a three-step process.

Like the term life analysis, start by considering whether you have any financial dependents and whether your life insurance provides them with needed protection. If it does, keeping some or all the cash-value policy in force likely makes sense.

If the policy isn’t needed to protect your family, the second question to ask is, “Is this policy an important part of my investment, estate or tax planning today?” The operative word here is “today.” Because these policies are often held for decades, your financial situation and today’s tax rules could be very different from when you purchased the policy. If the cash-value policy is no longer important to your financial plans, you’ve passed the second hurdle and might cancel your policy.

But before you do, there’s one more question you should ask: “Is this policy an attractive investment going forward?” Cash-value policies are typically not great investments at the outset, but that can change over time. For example, if you purchased a policy 15 or 20 years ago, it could have guaranteed interest rates that are 3% to 5%, which is very attractive in today’s environment. Also, since the gains on your cash-value policy are tax-free if you hold it until death, the returns on an after-tax basis might be even more compelling.

If you’ve evaluated your cash-value policy using these three questions and came up with “no” for all of them, it’s likely safe to assume you no longer need the policy. Before you cancel it, keep in mind that — because cash-value policies have an investment component — you’ll likely be taxed on any investment gain, so make sure you evaluate the impact on your overall tax bill. Also, if your policy still has surrender charges, consider whether it’s worth keeping it a few more years until the surrender charges decrease or go away altogether.

The IRS has something called a “1035 exchange,” which allows you to transfer the cash value of a life insurance policy into another life insurance policy, an annuity and certain long-term-care policies. With a 1035 exchange, you don’t pay any tax upfront. Instead, your current policy’s cost basis is carried over to the new policy and you pay taxes once cash is taken out in the future.

Depending on your situation, doing a 1035 exchange into, say, an income annuity or long-term-care policy could allow you to better meet your retirement goals while also deferring taxes on your gain. In the case of long-term-care insurance, there’s an additional tax advantage: If you collect benefits, they’re paid out tax-free, so you potentially eliminate all taxes on your gain.

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