Insurance Strategies: Giving Old Life Insurance a New Purpose

Later in life — when your children are on their own, you’ve retired, or you’ve paid off your mortgage — you may think you no longer need to keep your life insurance coverage, or that the benefit isn’t worth the cost.

If you own permanent life insurance, the policy may have a cash surrender value (CSV), which you can receive upon surrendering the insurance. Any gain resulting from the surrender (generally, the excess of your CSV over the cumulative amount of premium paid) will be subject to federal and possibly state income tax. Also, surrendering your policy prematurely may result in surrender charges, which can reduce your CSV.

You may be able to preserve tax-deferred gains in a permanent life insurance policy that you have owned for a long time by exchanging it for a new life policy with different benefits, or another type of stand-alone insurance product that better meets your needs. Under the federal tax code, this is known as an IRC Section 1035 exchange. However, it’s possible that you may not qualify for a new insurance policy because of your age, health problems, or other reasons.


Provide for Long-Term Care

You might consider exchanging your old policy for new life insurance with a rider that pays some long-term care expenses, a combination life insurance and long-term care policy, or a tax-qualified long-term care insurance (LTCI) policy.

With an LTC rider, any payouts for covered expenses reduce (and are usually limited to) the death benefit, and they are typically much less generous than those of a traditional LTCI policy. Optional benefit riders are available for an additional cost and are subject to the contractual terms, conditions, and limitations outlined in the policy; they may not, however, benefit all individuals.

For the same premium, a combination life/LTCI policy typically has a smaller death benefit than a life policy with an LTC rider, but payouts for covered long-term care expenses could be greater. Many of these hybrid policies require a substantial up-front premium that could be paid through an exchange, and buyers don’t have to worry about future rate increases or the issuer canceling the policy, both of which can happen with a long-term care insurance policy. Still, an individual should have a need for life insurance and evaluate the policy on its merits as life insurance.

A traditional LTCI policy may not accept lump-sum premium payments, but you could possibly make several partial exchanges from the cash surrender value of your existing life insurance policy to cover the annual premium cost. A complete statement of coverage, including exclusions, exceptions, and limitations, is found only in the policy.

Create an Income Stream

Another option is to exchange the CSV of a permanent life insurance policy for an immediate annuity, which can provide a stream of income for a specific period of time or for the rest of your life. Each annuity payment will be apportioned between taxable gain and nontaxable return of capital. By exchanging the CSV for an annuity, you will be giving up the death benefit. Annuity contracts generally have fees and expenses, limitations, exclusions, termination provisions, holding periods, and terms for keeping the policy in force. Any annuity guarantees are contingent on the financial strength and claims-paying ability of the issuing insurance company.

A 1035 exchange must be made directly between the insurance company that issued the old policy and the company issuing the new policy or contract. The rules governing 1035 exchanges are complex, and you may incur surrender charges from your current life insurance policy. In addition, you may be subject to new sales, mortality, expense, and surrender charges for the new policy.

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