When the nest empties, the need for life insurance diminishes. Baby boomers and retirees should think strategically about existing life insurance policies and future life insurance needs. Here is what to do with a life insurance policy as you approach retirement.
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1. Let your term policies expire. Most term life insurance policies are purchased to protect dependent children and are scheduled to expire when the kids are gone. You may be tempted (or encouraged by your agent) to replace that expiring coverage with something else. Save your money. A dependent spouse can use retirement assets, pension benefits, and Social Security to provide income protection.
2. Allow the cash value to grow tax-deferred. If you bought whole life insurance (also called permanent life insurance) years ago, you probably have built significant cash value inside the policy. One of the retirement and tax planning benefits of whole life insurance is that the cash value grows tax-deferred and perhaps tax free. The IRS considers policy dividends that create cash value to be a return of the premiums you paid over the years. You pay tax on the dividends only when the total dividends exceed the total premiums paid. Also, the IRS does not require you to pay tax until the policy is surrendered. Therefore, it can make sense to allow the cash value to grow and then surrender the policy when you need income that is tax free.
3. Use dividends to pay premiums. If you decide to keep an older whole life policy in force to provide tax-deferred income or for the death benefit, consider using policy dividends to pay premiums. This provides an immediate cash flow benefit to you. In many cases, the dividends are more than enough to pay the premiums and provide some tax-deferred growth.
4. Borrow against the cash value. One of the problems with cash value life insurance is that when you die, your beneficiaries receive the death benefit but not the cash value. It would be better if you can maintain at least some of the death benefit, but use the cash value while you are alive. One way to do this is to borrow against the cash value and not pay back what you borrowed. This can be done if what you borrow plus interest does not exceed the cash remaining in the policy. However, you have to worry about phantom income. If your loan balance equals your cash value and then you cancel the policy, you will be taxed on the amount that your loan exceeded the premiums you paid. This could leave you a large tax bill and no way to pay it.
5. Surrender and convert to a life annuity. Many insurance companies will allow you to surrender a whole life policy and use the cash value to purchase a life annuity. This can be an effective retirement income strategy if the conversion does not trigger a significant tax obligation. Check with your agent to see if this will work for you.
Life insurance needs change as you age. Be proactive and use a strategy that benefits your retirement planning.
Mark Patterson is an engineer, patent attorney, baby boomer, and author of The Failsafe Retirement System. He blogs on matters of personal finance and retirement planning at Tough Money Love and Go To Retirement.