I recently met with a potential new client to discuss managing his investments and whether he had enough to retire and maintain his lifestyle. As I reviewed his information I told him that he could retire but that he did not have much of a cushion and therefore, he would have to be prudent with how he spends money in retirement. As we took a closer look at his expenses, one thing that jumped out at me was the amount he was paying for life insurance. He had a substantial life insurance policy that he was paying over $1,200 a month for. My first question to him was why he needed life insurance-after all, he is divorced and has no children or dependents. After thinking about it for a minute or so, his answer was that he didn’t know.
The client explained to me that he bought life insurance when he was married in order to protect his spouse and that it never occurred to him that he should cancel the policy. My advice to him was to cancel the policy and that the money he saves on a monthly basis would provide him the cushion he needed in retirement. In my career, I have seen this many times where people have life insurance policies that they don’t need. There is a misconception out there that everyone needs life insurance but that is not the case. As I’ve said many times, life insurance is not an investment; it is a means of covering risk. The risk that you cover with life insurance is that someone will lose out financially upon your death. However, if there is no one financially dependent upon you, why have life insurance?
I recommend that everyone go through their life insurance policies to determine if they need them or not. Just because you purchased the policy 20 years ago doesn’t mean you should have it today. I have always believed that life insurance is like all other insurance and that is that it is need based. No one would buy boat insurance unless they had a boat. The same theory applies to life insurance. The questions isn’t if you’re going to pass away or not, because we know that happens to everyone; but rather, the real question is when you pass away, is a loved one going to have financial difficulties. If no, you don’t need life insurance. If yes, life insurance is something to consider.
If you decide to cancel your life insurance, the question is what you do with your policy. If it is a term policy, you can cancel it and just walk away. However, if you had a policy that was accumulating cash value, there are a few options. In deciding what option to take, the question is, what will your tax ramifications be?
Many people are under the mistaken belief that if you cash out a life insurance policy and receive the cash value, it is subject to tax. That is not necessarily the case. Don’t forget, in a life insurance policy you do have a cost basis and that is all the premiums you have paid. For example, if you had $50,000 cash value on a life insurance policy and over the years you had paid $60,000 in premiums, you can cash out your life insurance policy, receive the $50,000 and there will be zero tax consequences. On the other hand, if the cash value is $50,000 and the total premiums you paid were $40,000 when you cash out the policy, there would be a $10,000 gain which will be reported as ordinary income.
For those that are thinking about cashing out a policy where there will be a tax consequence, in order to avoid that tax consequence you can directly transfer your cash surrender value into an annuity. This is known as a 1035 exchange and there would be no tax consequences to the transaction. If this is an option that you are thinking about, you certainly should look at some of the no-load, no-penalty annuities offered by companies such as Fidelity, Schwab and Vanguard.
It doesn’t matter why you bought the life insurance, the question you need to ask yourself is whether you still need it today. If you don’t need life insurance, why pay for it? Therefore, if you have not reviewed your life insurance coverage, this could be an excellent time to do so. After all, why should you pay for something you don’t need? The money you save looks much better in your pocket than it does anywhere else.