Maturing Life Insurance Policies Create Tax Bills, May Shortchange You

Permanent life insurance isn’t quite permanent. Many permanent policies mature at age 100, sometimes at 95, and then pay out the cash value to the policy owner. If you outlive your policy, you and your heirs can suffer adverse tax and financial consequences.

After years of paying premiums for a policy you expect to remain in place until your death, you may lose the benefit of passing wealth to your heirs tax-free. Sometimes you won’t even get full value from your policy. And you’ll usually get a hefty tax bill too.

It’s sometimes possible to extend a policy to age 120, and while this solution isn’t perfect, it’s often the best fix available.

While the issue is most salient for people in their 90s, anyone with permanent insurance should review their policy and take action if necessary.

Permanent life insurance generally comes in whole, universal and variable universal life variants. All three bundle an investment component with insurance. When such a policy matures, it causes two problems.

First, your beneficiaries will not receive the death benefit. Second, a portion of the payout — often, a significant amount — be will be taxed as ordinary income (the payout’s cost basis, which is the total amount of premiums paid, isn’t taxed).

When a whole life policy matures, the cash value will equal the death benefit plus accumulated interest, if any — but owners of a universal life or a variable universal life policy may get another rude shock.

Universal policies unlink investment and insurance components of a policy in order to offer lower premiums. If investment results are poor, the cash value at maturity may be considerably less than the promised death benefit.

Ways to Fix the Problem

The first step is to find the maturity age of your policy or the policy owned by the individual you’re helping. Age 100 is the default, but if you bought your policy within the past 15 years or so, it’s probably 120. Some older policies mature at 95 or 96.

The easiest fix is to ask the insurer for a maturity extension rider to extend the policy’s maturity age to 120. There may be a small fee for the rider, however, not all insurers offer it.

Generally, the death benefit of a policy with an extension rider is the cash value of the policy at the original maturity date plus accumulated interest, without any additional premiums.

If the insurer grants the rider, you may be able to avoid a taxable event, and your beneficiaries will receive the policy’s benefits upon your death as originally planned, but it’s not certain.

The IRS may rule that you still owe tax at the policy’s original maturity date even if you forgo the lump-sum payout (the tax principle of constructive receipt comes into play here). Insurers are fighting the IRS on this, but it remains a gray area.

However, it’s still worthwhile because a maturity rider will secure the policy’s death benefit for your beneficiaries.

People with universal life policies may find it more difficult to secure the rider than those with whole life insurance, but even if you have a whole life policy, the insurer may not cooperate.

If your insurer won’t extend the policy, you may be able to buy a replacement policy with the now-standard age 120 maturity. For a relatively healthy individual in his or her 60s, swapping may be feasible, but may not be for those who are older or ill.

This is not a decision to make lightly, work with an independent financial adviser who doesn’t sell insurance to help you decide.

With a Section 1035 exchange you can swap an old policy for a new one without realizing a taxable gain, as long as the owner and insured are the same on the old and new contracts. Consult a tax pro to avoid problems.

Make sure you obtain the replacement policy before surrendering your existing policy to avoid being left without coverage.

If you can’t or don’t want to make an exchange and the maturity date is imminent, you can instead convert the policy into an annuity. This spreads out the tax liability over a number of years instead of having all the income land in a taxable lump in one year. A portion of each annuity payment is taxable.

As more people live to celebrate their 100th birthdays, a firmer answer on how the IRS and insurers will handle policies with too-short maturation dates should eventually arrive. In the meantime, policyholders need to take proactive steps if they wish to capture the full value of their “permanent” insurance policies.

Shomari Hearn is managing vice president of Palisades Hudson Financial Group in Fort Lauderdale, Florida. He holds the Certified Financial Planner (CFP®) and IRS Enrolled Agent (EA) designations. Palisades Hudson Financial Group is a fee-only financial planning firm and investment manager based in Fort Lauderdale with $1.4 billion under management. It offers financial planning, wealth management, and tax services. Its Entertainment and Sports Team serves entertainers and professional athletes. Branch offices are in Stamford, Connecticut; Atlanta, Georgia; Portland, Oregon; and Austin, Texas. The firm’s daily blog and monthly newsletter covering financial planning, taxes and investing are online at www.palisadeshudson.com