Life insurance is a common tool for ensuring that estates have adequate liquidity to pay estate expenses and taxes. But recent changes to the estate tax have some people questioning whether the high premiums they’re paying are worth it when their estates are no longer likely to be hit by the estate tax.
With a $5 million exclusion amount and brand-new exclusion portability provisions, far fewer households have to deal with the federal estate tax. But is allowing unneeded life insurance to lapse the best solution?
Other than allowing a policy to lapse, what are policy owners’ other options for disposing of their unneeded policies? Surrender, sale, and replacement are the most common options; but each option has unique consequences, necessitating close analysis in each case to derive the highest net benefit.
Option #1: Surrender
Surrender of a policy to the insurance company in exchange for the policy’s cash value is one option for disposing of an unneeded life insurance policy. But surrender or sale of a life insurance policy can result in an ordinary gain (or loss) to the policy owner and losses on surrender are rarely deductible.
On surrender of a policy for its cash value, amounts received in excess of "aggregate premiums or other consideration paid" are taxable income [I.R.C. §72(e)]. In other words, if the person surrendering the policy receives more in the surrender than they paid in premiums, they will be taxed on that amount.
In a full surrender, calculation of aggregate premiums is usually relatively simple. But in the case of partial surrender, calculation of “aggregate premiums or other consideration” is particularly complex.
Another important consideration in surrender of a policy is whether there are policy loans outstanding on the policy at the time of surrender. Surrender of a policy with an outstanding loan can result in the policy-owner realizing ordinary gain in the amount of the outstanding loan at the time of surrender. That result holds even if the surrender doesn’t yield cash to the policy-owner.
Keep in mind that surrender isn’t an all or nothing proposal. Surrender can be either partial or full. If premiums are too high, consider using a partial surrender to extract some of the policy’s value while maintaining some life insurance coverage and minimizing the tax burden of the transaction.
Option #2: Life Settlements
Another alternative to allowing an unneeded insurance policy to lapse is to sell the policy to investors in a life settlement transaction. In a life settlement, the policy’s owner receives a cash payment, and investors receive the right to the policy’s death benefit. In many cases, a life settlement will generate more cash than surrender to the life insurance company. But the income tax consequences of sale and surrender are radically different, necessitating
close analysis in each case to determine which method will net more for the policy’s owner.
The IRS issued guidance in 2009 that clarified the income tax treatment of life settlement transactions
(Rev. Rul. 2009-13 & 2009-14), holding that sale of a life insurance policy is treated differently than a surrender. That can have a massive tax impact on the person selling the policy.
When a policy is sold, the taxable gain calculation is similar to where a policy is surrendered, except that premiums paid must be reduced by the value of life insurance coverage provided by the policy to the date of sale. As a result, sales almost always result in more severe tax consequences than surrenders. If premiums are allocated 100% to life insurance coverage—as in a term policy—the amount received on the sale is 100% taxable as ordinary income.
Option #3: Replacement Policy
Rather than surrender a policy that’s no longer needed for estate tax purposes, policy-owners have the option of replacing the policy with one that is better suited to their current life insurance needs [IRC §1035]. Tax-free exchange can be used to reduce policy premiums or otherwise secure more appropriate coverage based on the insured’s changing needs. Also interesting to some individuals is the ability to exchange life insurance policies for annuity products.
Surrender of a policy for a policy with lower premiums is often the goal of a tax-free exchange. But surrender is a viable option for reducing premiums only where the insured hasn’t suffered any negative health changes in the years between issuance of the first policy and issuance of the replacement policy. The underwriting process will need to be repeated for the replacement policy which could dramatically increase premiums and reduce the benefits available in the replacement policy.
But the tax-free nature of the transaction shouldn’t blind insureds to other aspect of the transaction. For instance, the value of the exchanged policy may be applied to pay expenses,
like a commission, in the year the policy is issued, severely reducing the value of the replacement policy.
Also, where a replacement policy is issued in an exchange, the insurance company gets another shot at cancelling the policy since a new two-year contestability period will commence on issuance of the replacement policy.
The Final Word
Allowing an unneeded life insurance policy to lapse is not the only option for policy-owners who aren’t sure whether they want to continue making premium payments. Two methods for disposing of a policy, surrender and sale, have a similar result—the policy-owner receives cash in exchange for the policy—but with differing tax consequences to the owner. Close analysis of the net benefit is necessary where a client wants to totally divest himself of ownership of a policy.
There are also a couple of options for individuals who don’t want to continue making premium payments on a policy, but who may have some need for continued life insurance coverage. Rather than sell or surrender the policy, these individuals can replace the policy with a more appropriate policy in tax-free exchange. Alternatively, they can make a partial surrender of the policy; although, unlike a tax-free exchange, a partial surrender can result in income tax liability for the policy’s owner.
Finally, when determining whether and how to dispose of a life insurance policy that’s no longer needed, don’t forget an important part of the calculus: We still don’t know what’s going to happen to the estate tax in 2013. What you thought was a superfluous policy may turn out to be needed.
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See also The Law Professor's blog at AdvisorFYI.