Life Insurance’s Nasty Surprise

Life insurance is one of the most complicated and confusing financial products in the marketplace and, for the uninformed, can create some nasty surprises under certain circumstances. Life insurance policies fall into two broad categories: ‘term’ life insurance and ‘permanent’ life insurance. Of the two, term insurance is much more easily understood. 

With term insurance, you typically choose a policy for a specified death benefit, say $1,000,000, with level premiums paid over a specified period of time, say fifteen years. Each year you pay the premium and if you die during the year, your beneficiary receives the $1 million. If you don’t pay the premium, the policy terminates. Typically you have the right to ‘convert’ your term policy to a permanent policy anytime without evidence of good health. At the end of the fifteen years, you must convert your term policy to a permanent policy (with much higher premiums) or the policy will lapse. All of this is fairly straight-forward but there are a couple of potential ‘nasty’ surprises you should be aware of.

Nasty surprise #1: Limited conversion right. Some policies terminate the guaranteed right to convert the policy prior to the full term of the policy. For example, you purchase a 20-year term policy for $1 million but the conversion privilege ends in the seventeenth year. Most people never remember this… so when the policy is in its final year (year 20) and they realize the policy is about to lapse and they are uninsurable because of an illness, they realize, too late, that they’re out of options. Recommendation #1: Check with your agent to learn how your conversion privilege works. If it ends before the policy ends, be sure to make a note and review your health status and insurance needs before the conversion option ends. Recommendation #2: Purchase only term policies where the conversion option lasts the full term of the policy.

Nasty surprise #2: High cost of conversion. If you find yourself in a situation where your health status has changed and rendered you either uninsurable or highly rated and, still needing insurance, you desire to convert to a permanent policy, many companies only offer conversion to an ‘uncompetitive’ permanent policy versus their most consumer-friendly policies. Insurance companies are smart. They know if you are converting a term policy, most likely you are doing so because your health is poor and they want to protect themselves, at least partially, by selling a policy where their profit margins are much higher. For example, one company offered a $1 million 15-year level term policy for a 50-year-old male for $1,480 per year. If he decided to convert at age 65, his premium would be $30,000 per year! A more competitive, highly rated company charged $2,000 per year for the term but converted at age 65 to a permanent policy with a premium of $19,000. Recommendation: Buy a term policy that allows you to convert to any policy the company currently offers to sell or at lease allows conversion to a range of competitive policies. 

With permanent life insurance, you are buying a combination of a term policy plus a ‘savings’ feature. These come in a number of forms including whole life, universal life and variable life. Most policies allow you to ‘borrow’ from the cash value or savings that you’ve built up and here’s where you could run into:

Nasty surprise #3: Phantom income. You’ve been paying premiums for decades and along the way you’ve borrowed money from your policy for some event or, in many cases, to pay policy premiums. Eventually you lapse the policy either because you no longer need the insurance or because you don’t have the money to pay the premiums. Upon lapse, the insurance company ‘settles’ the loan and if you have a profit, you will owe income taxes on the gain but you might receive only minimal proceeds. For example, say you’ve paid in $20,000 and the total policy value is $30,000 which you’ve taken out as policy loans. Upon termination, you have a taxable gain of $10,000 but no cash to pay the tax. Recommendation: Monitor closely the tax implications of your policies. The best way to do this is have your agent review your policy details every couple of years.

Nasty surprise #4: Modified endowment. One great thing about life insurance is the industry has secured some favorable tax benefits for policyholders. One of those benefits is what we refer to a FIFO (first in; first out) income tax treatment. This means that when you withdraw money from a policy, it’s considered a return of your premiums paid until all such premiums have been withdrawn. A return of premiums is a non-taxable event…a good thing! Compare this to annuities which face LIFO (last in; first out) tax treatment. With annuities, any withdrawals are considered profits first until exhausted which are taxed as ordinary income…a bad thing! With permanent life insurance policies, if the ratio of cash value to death benefit gets too high, it’s treated as a ‘modified endowment’ which converts the policy, for tax treatment from FIFO to LIFO. This can inadvertently happen a number of different ways including contributing too much to a policy or through withdrawals. Recommendation: Before making substantial withdrawals or contributions to your policy (or terminating your policy), confirm that you will not run afoul of the modified endowment rules. Again, your agent can help you determine this.

Life insurance is a vital product for family and business financial planning and there many great companies, products and agents. Your best bet is to find a great agent who can guide you through the complexities and tailor a program for your specific needs.