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Keeping Life Insurance during Retirement - Or Not

By Chuck Yanikoski

Do you need life insurance when you're retired? This is not always easy to answer, and you may need to consult a professional advisor, or at least use good software, to help you decide. But here are the main reasons why you might: (1) if you or your partner would be left in serious financial jeopardy if the other died first; (2) if you need or desire to leave someone a big bequest at death, or to cover taxes, debts, or other expenses at death; or (3) if you have a dependent with special needs, whom you want taken care of long after you are gone.

There are also tax advantages to holding onto life insurance. Death proceeds usually go to the beneficiary free of federal income taxes. This means that all the increase in value, over and above the premiums that were paid, is generally tax-free income.

There are various options if you already have insurance, and need to keep it.

If you have term life insurance, and it looks like your need for insurance is permanent, then you probably have the wrong kind of insurance. You can usually convert term in-surance to permanent insurance, though this will mean paying higher premiums. You might also consider canceling the term insurance and starting from scratch with a new policy. But never cancel the old policy until the new one is actually approved, in case it isn't. And if your health is bad enough so that your life expectancy is short, your best bet might be to just continue the term insurance, rather than changing to a more expensive permanent policy.

If you have permanent life insurance, and if there is significant cash value, ask your agent for an illustration of how the policy might perform in the future. Generally, if your policy is not already paid up, and you continue paying premiums on it, your illustrated future cash values and death benefits will increase significantly. If you don't need that much growth, you may be able to reduce your premium payments or stop them altogether, either immediately or at some point down the road.

If you have insurance but do not need the death benefit, you have different options.

If you have term insurance you don't need, you can simply cancel it. If you are in poor health, however, especially if you think you probably will not live more than a few years, it might be smart to keep the policy going so that your beneficiary can collect the death benefit when you are gone. Another possibility: you might be able to get a "life settle-ment" (described a little further on) - but not all term policies are eligible for this ar-rangement.

Keeping a cash value policy as an investment can make sense even if you no longer need the death benefit, because of the tax advantages. There are two things you can do in this situation:

First, if you are retired, you should probably convert the policy to paid-up status, meaning the death benefit will be reduced and you no longer pay any premiums. This will turn the policy into a more efficient investment. However, if you can easily afford the premium payments and want to increase your tax-advantaged savings, you might even want to pay extra premiums, if your policy permits this, as many do. (Note: if you have a variable life policy, switching from Option B, which provides for an increasing death benefit, to Option A, which provides for a level death benefit, is another way for you to keep cash values in the policy.)

Second, you can withdraw ("surrender") from the policy an amount equal to the total of premiums that have previously been paid into it. Such withdrawals are tax-free, because they are considered to be a return of your premiums, not income. If you wish to with-draw more than that amount, you can borrow against the policy. Since this is a loan, it is also not taxed, and when you do eventually die, the loan will be repaid automatically from the tax-free death benefit of the policy. The main catch is that if your policy expires at a certain age (say, 100) and you live past that time, you could get stuck with a big tax bill.

If you decide to get rid of the policy, you have even more choices.

Surrendering it could be your best bet if you need cash, but a significant portion of the proceeds may be taxable. If so, spread the surrender over several years, if you can.

Turning the policy into an annuity means ending the life insurance aspect of it, and using the cash value to provide a lifetime income for the person insured under the policy. This can be a good choice if the insured person is healthy. Payments will continue for as long as the recipient lives.

Receiving "accelerated benefits" may be an option if you have a severe medical condition and a very short life expectancy. Many policies explicitly permit you to receive a portion of your death benefit early if you are gravely ill - and even if the insurance contract doesn't provide for this, insurance companies often allow it anyway.

A "life settlement" provides for a third party to purchase your policy and name itself as beneficiary. The third party will pay any future premiums, and will collect the death benefit when you die. In the meantime, they will pay you a cash amount (a "settlement") up front. This is more likely to be a good deal for you if premiums are still due, and you can't afford them - or if you need money right now. But most of what you receive in the life settlement will be taxable, unless you are already terminally ill. Compare all your options carefully before deciding on this, and shop around for a buyer, because you might get widely different offers. Also be alert to any charges imposed for the transaction, and to any issues relating to your medical privacy. Regulation of life settlements is spotty, so be extra alert.

Or let your kids take it over. If one or more children would like to be named as benefi-ciary and is willing to start paying the insurance premiums, you can easily make those arrangements. You can withdraw or borrow some or all of the cash value first, if you need it. If you don't need it, it's a simple, tax-free way to pass an inheritance down the line without it having to go through probate court.

Or, finally, give it away: consider naming a charity as your beneficiary.

It is almost always best to talk with an agent for your existing life insurance company about your options. The agent can get you computer-generated illustrations of future premiums, cash values, and death benefits, and can show what these might look like un-der different options that you have. This information will be central to the decisions you make. Your agent may be able to help arrange a life settlement, but not all agents deal with them.

An agent may suggest that you replace an old policy with a new one. Just because the agent will get a commission on the new sale does not mean that this is a bad idea, but be careful, and ask for a second opinion if you are not sure.

While you're at it, review with the agent all beneficiary and ownership arrangements on existing policies. Perhaps the original beneficiary is no longer alive, or is no longer the best person to receive the proceeds. If your estate is the beneficiary, it is usually better to designate a particular person or persons, or a trust.