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How to Profit from Your Old Life Insurance Policy

Last update on: Oct 17 2017
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What should you do with that cash value life insurance policy you no longer need?

Many of you have old cash value policies that aren’t doing you any good. Perhaps you bought them years ago when your insurance needs were much higher. Your insurance needs changed, because of increased wealth, divorce, or a spouse’s death. Or maybe you were persuaded to buy the policy as an investment and are not impressed by its returns. Whatever the reason, the question is what should be done with the policy now.

Since the policy has a cash value, the last thing you want to do is let it lapse (by not paying any future premiums) or surrender it to the insurance company. If the cash value has a profit (the value exceeds the premiums you paid in), then the excess amount will be taxable to you. If the cash value is a loss (the value is less than your total premiums paid), then you’ll lose the opportunity to make use of the loss. It would be considered a personal expense with no tax advantages.

A better strategy is to roll over the cash value to another policy. Section 1035 of the tax code allows you to rollover a cash value tax free to either a new cash value policy or to an annuity. This opens up several possibilities.

If you no longer need cash value insurance, you might switch the policy to a tax-deferred annuity to build additional money for retirement. Suppose you paid $60,000 of premiums into a policy and have a cash value of $40,000 to show for it. You have a loss of $20,000. Cash in the policy and that $20,000 is lost forever. But you can purchase an annuity with the cash value through a section 1035 exchange. In that case, your tax basis in the annuity is the $60,000 you put into the life policy. That means the first $20,000 of earnings from the annuity will be tax free. (The earnings are tax free as long as they remain in the annuity. But they become taxable when distributed.) You’re using the loss on the insurance policy to shelter future gains from the annuity.

Suppose the cash value were $70,000. Then you have a $10,000 gain. That would be taxable if you simply cashed in the policy or let it lapse. But it remains tax-deferred if you roll over the cash value to an annuity. You’ll be taxed only when the gain is distributed.

Suppose you still need some life insurance protection. But you’ve realized the insurance need isn’t permanent. It is needed only until your mortgage is paid or the children are out of college. You also realize that the cash value life is an expensive way to buy the coverage. Then you could roll over the cash value to an annuity and purchase term insurance for the amount of coverage you need. The term premiums should be less than the whole life premiums you are paying, and the cash value will to toward you retirement fund.

Or you might want to roll over the cash value into one of today’s variable life policies. These policies let you choose how the cash value is invested among different mutual funds made available by the insurer. If the investments do well, the death benefit and cash value increase much faster than with regular cash value insurance. Check the January 2000 issue or the web site archive for details.

When you look at annuities, look for annuities with low expenses and low commissions. Also, try to avoid annuities with surrender penalties. Vanguard and other mutual fund companies offers no-load, no-surrender-penalty variable annuities with several investment options.

A final option is to give the policy to charity. Usually when you transfer ownership of the policy to a charity you get to deduct your cost basis, which generally is the total premiums paid. The charity names itself beneficiary of the policy. Check with your tax advisor for details.

One trick to rolling over or transferring a policy is that you need a statement of your cost basis in the policy from your old insurer. Insurers don’t put a lot of effort into generating these statements. But without this statement your basis in the new policy is assumed to be zero, and you don’t get any of the tax benefits. As often as 50% of the time the old insurer does not issue the statement of basis. So you or your new agent might have to harass the former insurer to get the statement is issued.

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