When entering retirement, it’s common to simplify your budget as much as possible by cutting all unnecessary expenses. Nix the expensive work wardrobe. Downsize to a smaller house. Stop making IRA and 401(k) contributions. Cancel your life insurance policies. Hold on. Not so fast. That insurance might come in handy during retirement.
Income replacement is the primary purpose of life insurance. Since most retires aren’t working, having life insurance can seem like a solution in search of a problem. But insurance can serve other purposes as well. Below are five reasons you may want to keep your life insurance during retirement.
It’s not a given that retirees don’t need income replacement protection. More and more people are choosing to work part time during retirement in order to supplement their income. If you choose to work and your spouse is counting on that income, life insurance can be a good way to replace it if something happens to you.
Life insurance can also help replace pension income that stops or is reduced when the pension holder dies. Those relying on Social Security could see a similar benefit from life insurance. When one spouse dies, the surviving spouse receives the higher of the couple’s Social Security checks and the lower benefit stops. In all of these cases, life insurance can be an effective way to protect the income of the surviving spouse.
Tax Free Withdrawals
If you have a permanent life insurance policy (such as whole life) that has built up cash value over the years, you can use that cash value in a variety of ways. First, you can use it to make premium payments on the policy. This can be a good way to keep the insurance while still cutting your expenses.
You can also withdraw a portion of the cash value, which is not taxable as long as you take out less than what you originally paid in. Any amount over that will be taxed. Borrowing against the cash value is another common way to access the funds. Rather than paying the money back, you can choose to have the loan plus any accumulated interest subtracted from the death benefit after you die. The proceeds from the loan are not taxed as long as the policy does not lapse or get surrendered before the loan is paid back. Before withdrawing or borrowing against the cash value in your policy, meet with your adviser to see how those actions will affect your taxes, premium payments, and death benefit.
Chances are good that you’ll leave more than just money to your heirs. Maybe you have a family business or a vacation home that has been passed down over the generations. If you have three children, but only one is interested in taking over the business, how do you treat everyone fairly? Life insurance can be a great way to provide liquidity to your estate so you can pass the business to the child that is interested and give the remaining children an equivalent amount in cash.
Under current tax laws, the top federal gift and estate tax bracket is 35% and the exemption is a little more than $5 million per person. Basically, with a little planning, a couple could avoid estate taxes as long as their estate was worth less than $10 million. That means the vast majority of people do not need to worry about the estate tax. However, the current laws are scheduled to “sunset” at the end of 2012 and will revert to the previous 55% tax and $1 million exclusion. Unless changed by Congress, the new law will result in many more people having a potential estate tax liability. Life insurance can help protect against that liability and preserve an estate for heirs or charitable giving.
Long-Term Care Insurance
As you move into retirement, you may be in a position where you’re less concerned about life insurance than you are about long-term care insurance. If you have a cash value life insurance policy that you no longer need, you might want to consider converting that into a life insurance policy that has a long-term care rider. You can accomplish that by doing a tax free transfer (a 1035 exchange in industry lingo) of the cash value from your current policy into the new policy.
The new policy with the long-term care rider will provide you with several options. As discussed previously, you can always withdraw what you put into the policy if you end up needing the money. If you choose to keep the policy in force and die without needing long-term care, the insurance company will pay a death benefit to your heirs. If you need long-term care, however, you can use the policy to help cover those costs instead of using it as life insurance. In short, this type of policy gives you added benefits and flexibility.
While not appropriate for everyone, life insurance can play an important role during retirement. Work closely with a trusted adviser to see if maintaining your policies makes sense for you.
FPA member Joseph R. Hearn is the Vice President at Teckmeyer Financial and author of the books If Something Happens to Me and The Bell Lap: The 8 Biggest Mistakes to Avoid as You Approach Retirement.