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.