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What to do with life insurance you no longer need

By: Kimberly Lankford

You may have bought life insurance as a smart way to protect your family financially if you died and your income stopped. But your financial needs and priorities can change through time. After your kids are supporting themselves, your mortgage is mostly paid off, your savings have grown, and you’re nearing retirement or already retired, then protecting your income may no longer be your primary concern. Instead, you may now be more worried about outliving your savings or affording the potentially large cost of long-term care. If you have a permanent life insurance policy that has built up cash value through the years, there are tax-smart ways to use the policy to help protect your finances from these different risks through time.

There are two kinds of life insurance: term and permanent. Term insurance has the lowest annual premiums and provides life insurance for a fixed amount of time, such as 10 years, 20 years or 30 years. With permanent life insurance, on the other hand, the insurance coverage has no end date and the policy also builds up cash value, like a savings account. It can take a few years for the cash value to accumulate because of the policy’s expenses, but after a decade or more you may have built up a large cash value that you can access for any reason — whether it’s for emergencies, a house down payment, or retirement income. Money you take from the cash value is subtracted from the death benefit.

There are several ways to access the cash value, each with different tax consequences.

You can withdraw the cash value up to the basis (which is the amount you paid in premiums through the years) without having to pay taxes on the withdrawal. Any withdrawals beyond the basis, however, are subject to income taxes.

Or you can borrow money from the cash value. You pay interest on the loan, but you don’t pay any taxes on the money as long as you don’t drop the policy. If you die with a loan outstanding, the balance is subtracted from the death benefit and is not taxable. (If you drop the policy with a loan outstanding, the balance is considered a withdrawal and any amount above the basis can be taxable.)

But there may be a more efficient to way to use the policy to protect against different risks. You can make a tax-free-transfer, called a “1035 exchange,” from the life insurance policy’s cash value to buy an annuity or pay long-term care insurance premiums. If you had cashed out the life insurance policy first, rather than making the 1035 exchange, you would have had to pay income taxes on any gains. With a 1035 exchange, there is no tax bill at the point of exchange. If you exchange into an annuity, you won’t have to pay taxes on your gains until you start receiving your annuity payouts in the future thereby allowing you to defer your tax bill for several years. If you exchange into a long-term care policy, you could potentially avoid the tax bill altogether since long-term care benefits are currently not taxable.

You can make a 1035 exchange from the life insurance into several kinds of annuities. If your main concern is outliving your income, you can use the cash value to buy an immediate annuity that pays out every year for the rest of your life, no matter how long you live. Or you can get a deferred-income annuity, which delays the first payment for several years and then pays out a larger annual benefit for the rest of your life. The conversion is tax-free, but you’ll pay taxes on part of the payouts when you receive the money, based on the proportion of your basis to your gains (the basis continues to be the amount of money you paid in life insurance premiums through the years).

If you’re most concerned about long-term care costs, you can make a 1035 exchange into a hybrid long-term care/life insurance policy that either pays out if you need care or pays your heirs a death benefit if you pass away without needing care. Current tax rules allow you to receive the long-term care benefits tax-free, and your heirs won’t have to pay taxes on any death benefit thereby allowing you eliminate taxes altogether on the cash value gain you transferred from your original permanent life insurance policy.

You can either transfer all of the cash value directly to the long-term care or hybrid policy, or you may be able to gradually transfer some money from the cash value every year to pay long-term care premiums, if permitted by the insurer (some insurers don’t permit these partial transfers because of the administrative hassles, especially if you’re moving the money from one insurer to another).

The tax rules for these transfers can be complicated, especially if you have a policy loan outstanding. And you need to make the transfer directly from the life insurance to the new policy for the transaction to be tax-free. Make sure to work with a knowledgeable agent if you are considering a 1035 exchange to ensure that it is processed properly and you don’t end up jeopardizing the tax benefits.

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