If you're saving money regularly now, will you still need your life insurance policy when you retire? And will the same policy you have today meet your needs after you leave your job? It's better to answer these questions sooner rather than later.
"This is not something to be thinking about the day before you retire," says Bruno Graziano, a senior analyst with CCH, a tax consulting firm in Riverwoods, Ill. Before you can figure out the future of your policy, however, it's important to understand the assets you have today.
1. Term insurance: cheap until you get older
Life insurance is generally defined as either term or permanent, and there are several flavors of the latter, including universal, whole life and variable life. It's important to understand the basics of each type of product as well as their advantages and disadvantages.
With term insurance, a policyholder purchases insurance and pays premiums for a set period, typically 10-20 years. If the policyholder dies within that period of time, a death benefit is paid to the policy's beneficiaries. When the policy ends, it can usually be renewed for another term. However, as the policyholder gets older, the rates for term insurance usually increase and may become cost-prohibitive.
According to Bruce Udell, author of "Advanced Estate Planning, Simple Solutions to Complex Problems," 65-year-olds who want to buy policies with 20-year terms should expect to pay about three to four times more for coverage than if they were 50 years old. The advantage of term insurance is that even though premiums increase with the age of the policyholder, they are still cheaper than permanent life insurance.
A term policy purchased during the working years could be timed to expire when the insured is ready to retire. Once the term is over, however, there's no death benefit, and your beneficiaries don't receive any payout.
"One of the things you always have to look at with term insurance is what happens when the clock stops," says Ben Jacoby, a senior financial adviser with Brinton Eaton Wealth Advisors in Morristown, N.J. If you have enough money saved to fund your own expenses and your children are grown and aren't dependent on your income, then you probably don't need another policy.
"From an income protection standpoint, I don't see a need for most people to have life insurance at the point of retirement," says Brad Levin, a certified financial planner with Householder Group, a financial planning company in Encino, Calif. "If they do, they're probably going to need a policy for just a few years anyway. It would be cheaper for them to just find another term policy."
Term policyholders will likely have the option to convert their existing term insurance into a permanent one. To determine if it's worth it, check the language of your contract to find out when you can do it, how much more you'll pay in premiums, and if you'll need a medical exam to prove that you're healthy.
2. Permanent insurance a costly alternative
If you anticipate that you will need insurance for several years longer than what term insurance offers, another option is to purchase a permanent policy. It could be kept for life as long as the premiums are paid. However, the premiums are much higher than comparable term insurance rates.
The premium is higher because part of it is placed in a special savings fund known as the policy's "cash value." Over several years of payments, the cash value amount adds up and earns interest.
"Eventually, you could stop paying the premiums and the cash value should support the policy for the rest of your lifetime," says Levin. This would be one less expense in a fixed income retirement.
"On the other hand, if the policy performed well according to expectations, you as the policyholder could be able to start taking loans against the cash value of the policy on a tax-free basis." As an example, a life insurance policy with a death benefit of $100,000 might build up a cash value of $25,000 after several years. The policyholder could then borrow some of that money, effectively generating an additional stream of retirement income. It's important to note that the death benefit could be significantly reduced if a loan is taken out, and withdrawing the entire cash value would effectively cancel the policy.
In order to keep the death benefit, the policyholder would have to repay the loan with interest. The insured would once again be making payments on the policy.
3. Understand federal estate tax rules
Permanent insurance can be a good estate planning tool for high net worth individuals if structured properly.
"The federal estate tax currently kicks in for estates above $2 million," and life insurance payouts figure into the equation, says Graziano. "Although the death benefit from a life insurance policy is excluded from the recipient's income, unless the policy is owned in the correct manner, the proceeds will be included in the estate for tax purposes."
Owning it "in the correct manner" means not owning it at all. "The life insurance policy should be in an irrevocable trust or owned by your children or somebody other than you, so that it's not taxed in your estate," says Udell.
If you already own a policy, transferring it to a trust after the fact is possible, but it can be tricky. "If the insured dies within three years of the transfer, the insurance proceeds are going to be drawn back into his estate just as if the policy had never been transferred," says Graziano. Work with an estate planning professional for specific advice. Other insurance products may be suggested, such as survivorship insurance (also known as second-to-die insurance), that are appropriate for estate planning.
4. Shop around
No matter how old you are, it's a good idea to periodically compare your life insurance policy to others on the market. "Every now and then the National Association of Insurance Commissioners changes the interest rates that are required to be used for guarantees in life insurance policies," says Udell. "It behooves you to shop your policy every five years, especially if you currently have cash value insurance. If you are in good enough health, you could get a cheaper policy."
Before making a switch, check the terms and conditions of your current policy. You'll probably have to pay surrender charges, and you might owe taxes after the transaction.
If you have a cash value policy, monitor its performance just as you monitor the funds in your retirement accounts. "Get an 'in-force ledger' from your insurance company every single year to make sure the policy is performing the way that it was illustrated," says Udell. "Otherwise, if the policy earns a lower interest rate than was projected at the beginning, the cash value could run out, and you'd have to start over with a new policy."
An alternative option is to buy insurance that has a guaranteed payout, but the premiums would be higher.
If you want another policy, you might be able to exchange it for your old one tax-free. "There are some mechanisms in the tax code that allow you to exchange a life insurance policy for another or for an annuity, similar to a 1031 exchange in real estate. For life insurance, it's called a 1035 exchange," says Udell.
5. Look beyond employer insurance
The cheapest life insurance available may be the group insurance sponsored by your employer, but it shouldn't be your only source of coverage. "Employer insurance is clearly a benefit, but you don't want to depend exclusively on it. When you leave the company, you may not have the right to convert that group policy to an individual policy," says Udell. "You'll want to buy some term insurance of your own. Otherwise, you're basing your insurance program and the financial security of your family on this employer's plan."6. Don't expect insurance to replace retirement savings
If you don't have a lot of money saved for retirement, don't expect a cash value policy to be your only savings strategy. It takes several years for cash value insurance to build up a substantial savings. If you're older and hope to retire in a few years, it's probably best to buy a term insurance policy to protect your dependents and fund a retirement account to build wealth.
"It's not financially beneficial for someone in their late 50s to purchase a cash value policy just for asset accumulation purposes," says Levin. "The cost of insurance is going to be higher and there's not going to be a lot of time to let the cash value build up significantly.
"If you're not financially ready for retirement, you'll be better off maximizing an investment vehicle that's not an insurance policy -- like a 401(k), IRA or Roth IRA."
7. Consider your settlement options
After retirement, if you don't need your life insurance policy, you could sell it in a "life settlement" transaction. According to the Life Insurance Settlement Association, a life settlement is the sale of an existing life insurance policy to a third party for more than its cash surrender value, but less than its net death benefit. The original owner of the policy is typically someone who is age 65 or older. The policy would eventually pay the investor the benefit. "For a person who's over age 70, they could receive around 20-25 percent of the policy's face value," says Graziano. So someone might receive $250,000 cash to sell a policy that has a $1 million death benefit.
Not everyone believes third party life insurance settlements are a good idea. "They are very controversial," says Jacoby. "They're getting a lot of states' attention these days, both from an ethics point of view and an abuse point of view."
The problem occurs when a person takes out a policy with no intention of receiving the benefit. They just buy it to cash out with an investor. "Most policies do not have a specific prohibition of them," says Jacoby, but insurance companies may include language in future policies prohibiting third party sales. Settlements are regulated by state insurance departments, so different rules apply by state.
A third party life settlement is not to be confused with a viatical settlement. The latter is an existing policy owned by a terminally ill client who would presumably use the money for medical expenses and final estate planning. Generally speaking, life insurance settlements are offered to individuals who do not have catastrophic medical problems.
Life insurance isn't for everyone. As you approach retirement, be sure to evaluate whether or not you still have a need for it. It's probably best to get an opinion from a disinterested third party, such as a fee-based financial planner who does not sell insurance products at all.