by Casia Chappell, CFP®, CPWA®
Vice President
Wealth Planning
Have you ever looked at something you've had for a long time and thought to yourself “Do I still need this?” or "I paid a lot for this … do I keep it?" This happens frequently when evaluating life insurance purchased in prior years.
Life insurance can be an important component of an individual or family’s financial situation when it fulfills a specific purpose. It’s most impactful when used to fill the gaps between one's available resources and the needs of a spouse and/or dependents, or when used to provide an influx of necessary liquidity, especially for estate taxes or business uses. It is important to note, however, that the need for life insurance, the amount appropriate based on your need and the ideal type of life insurance will evolve throughout your life.
When evaluating an existing policy one of the first questions you should consider is “What purpose does this policy serve in the context of my unique circumstances today and in the future?” If the policy was purchased many years, or even decades previously, you may discover that the original purpose that the policy was purchased for no longer exists. For example, a policy purchased when an individual has a young family and emerging career may no longer be needed to replace decades of lost earnings and liquidity to cover childcare and education costs. Or, perhaps, the amount needed has changed if the death benefit intended to provide liquidity for one's heirs is no longer appropriate given their current estate size and structure.
Another element that may evolve over time is the type of life insurance required to fulfill that need. There are two main categories of life insurance: term insurance and permanent insurance. Term insurance remains in force for a specific timeframe, normally a set number of years, and then expires. If the insured passes away during that period, then the policy will pay the death benefit to the beneficiary. If the insured does not pass away, then the policy will lapse with no payment to any party. Permanent insurance remains in force so long as premiums are paid, or other conditions are met. There are a few different types of permanent insurance, but most include an investment element and can be used in more complex financial and estate planning.
Generally speaking, term insurance is the ideal solution for younger individuals who are seeking to fill the gap between their resources and needs, as term insurance is more cost efficient. Permanent policies are a better solution for liquidity needs in estate or business cases.
The Federal Estate exemption is a good example of why life insurance should be evaluated in the context of future needs. The exemption is currently $12.06 million, but it is set to revert to $5 million, adjusted for inflation, at the end of 2025. This means that in a few years, there will be significantly more individuals and families whose estates will be subject to the 40% federal estate tax, in addition to any applicable state level estate taxes. Life insurance can be used to provide liquidity to heirs to cover an estate tax liability.
There are several options when reviewing an existing policy including retaining the policy, cancelling, exchanging, or changing ownership. These generally apply to permanent policies, which are more expensive than term policies, but may apply to both types of policies.
There could be compelling reasons to keep an existing policy, even if the original reason for purchasing it has changed. For example, a significant appreciation of the underlying investments that would cause adverse tax consequences if liquidated. Another might be if the policy has specific features or riders that are desirable or no longer available such as a long-term care rider.
If needs have changed, but still exist, or there are other reasons to retain a policy, a tax-free exchange to a new policy or non-qualified annuity via a 1035 exchange may be an appropriate solution. This could allow the policy owner to benefit from a more affordable policy with a lower premium and death benefit, purchase a policy with a rider that provides long-term care benefits, or even create an income stream.
For individuals who are charitably inclined, some policies are ideal candidates for philanthropic giving. It is important to work with the intended charitable organization to ensure they’re capable of accepting non-traditional assets like life insurance and consult with your tax professional to evaluate the potential benefits of this type of transaction.
Cancelling a policy, particularly a permanent policy, should only be done after careful consideration of other options with your professional partners. If the premiums are unsustainable relative to the benefit, the policy no longer serves an identifiable need and there aren't significant tax consequences, then cancellation may be the appropriate course of action.
Working with your trusted professional partners to review any existing policies will help you determine the most appropriate course of action.
Ferguson Wellman, Octavia Group and West Bearing do not provide tax, legal, insurance or medical advice. This material has been prepared for general educational and informational purposes only and not as a substitute for qualified counsel. You should consult qualified professionals to understand how this information may, or may not, apply specifically to you.