Time to Reassess Your Life Insurance After Tax Reform

The new tax law is prompting policyholders to review their life insurance to see if the coverage still makes sense.

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It has always been a good idea to regularly review your life insurance policies to make sure they still meet your needs. But the changes in tax law provide extra incentive to reassess your policies’ costs and benefits.

The new tax law roughly doubled the federal estate-tax exemption, to $11.18 million in 2018. So the vast majority of people who originally purchased policies to help cover estate tax are no longer subject to the tax. The new law also created more favorable tax treatment for people who sell their policies to investors.

That doesn’t mean you should rush to dump your policy. Some state estate-tax exemptions remain relatively low, and the federal exemption is scheduled to revert to $5 million, adjusted for inflation, in 2026. And even if your policy no longer fits its original purpose, life insurance may offer other benefits—such as creditor protection—that are important to you. You may also be able to modify the policy to make it more attractive as an investment vehicle or exchange it for another policy better suited to your goals.

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The bottom line: Policyholders should keep close tabs on their policy’s health and weigh all their options before surrendering or selling the policy.

Start by getting in-force illustrations on permanent policies every year. Review the projection of the policy’s future value, and check whether the coverage will run out at some point.

Once you’ve studied the numbers, you may be reluctant to keep paying hefty premiums for a policy that no longer suits your needs. But before dumping it, weigh the tax consequences. If you surrender the policy to the insurance company, you’ll have a taxable gain to the extent the cash value exceeds the premiums paid.

Policyholders Have Options

Whole life policyholders might instead take their policies to “paid-up status,” meaning they stop paying premiums and get a reduced death benefit. You avoid the tax bill, and the policy may become “a modestly appealing quasi-fixed-income investment,” says Scott Witt, a fee-only insurance adviser in New Berlin, Wis.

Another option: Use a tax-free 1035 exchange to swap your policy for a hybrid product that blends life insurance with long-term-care coverage. These products come in various forms, but they often combine a whole or universal life policy with a long-term-care rider. If you don’t use the long-term-care coverage, your heirs get the death benefit. “That can be a very strategic retirement-risk planning strategy” for people who no longer need a large death benefit, says Jamie Hopkins, director of the retirement income program at The American College of Financial Services.

Policyholders who can’t find any attractive alternatives might consider a life settlement—meaning you sell your policy for a lump sum, and the buyer becomes responsible for paying future premiums and gets the death benefit when you die.

Transaction costs can eat up a big chunk of the gross purchase price, and sellers often receive just a fraction of their policy’s face value. But in some cases, a life settlement may be the only reasonable choice. For example, many people who purchased life insurance for estate-tax purposes have guaranteed universal life policies, which have little or no cash value, Witt says. For those who don’t want to hang on to these policies, a life settlement may be “the only real exit strategy,” he says. “You’re not going to get good value” compared with the intrinsic value of the policy, he says, “but it’s better than walking away and getting nothing.”

Tax reform also improved the tax picture for people selling their policies in life settlements. Previously, the seller’s cost basis was reduced by mortality, expense and other insurance charges, resulting in a larger taxable gain. The new tax law removes that adjustment, trimming the tax bill for policy sellers.

A fee-only insurance consultant can help you weigh your policy options. Find a list of consultants at www.glenndaily.com.

Eleanor Laise
Senior Editor, Kiplinger's Retirement Report
Laise covers retirement issues ranging from income investing and pension plans to long-term care and estate planning. She joined Kiplinger in 2011 from the Wall Street Journal, where as a staff reporter she covered mutual funds, retirement plans and other personal finance topics. Laise was previously a senior writer at SmartMoney magazine. She started her journalism career at Bloomberg Personal Finance magazine and holds a BA in English from Columbia University.