This is, unfortunately, an all too common story I have heard. A new client of mine told me that his father bought a $500,000 universal life insurance policy for himself 26 years ago, hoping that when he died he would leave half a million dollars to his children (26 years ago, that was a lot of money).
Premiums and Cash Value
The premium for the insurance policy is $9,000 a year. At some point, his dad asked my client to take over the premium payments. Between the two of them, they have already paid in a total of $234,000, but the cash value of the insurance was only $103,000. (For more, see: Estate Planning for Beginners, Part One.)
Next year, his dad will turn 80 and below is the in-force illustration the insurance company gave him. Basically, even if he continues paying the premium, the insurance will lapse when his dad turns 83, a mere four years from now. If that happens, they will have paid $270,000 to the insurance company, all for nothing. To avoid that outcome, his dad literally has to die in within the next four years.
When his dad turns 80, the mortality expense of the life insurance escalates to $40,000 - $50,000 per year, far more than the annual premium. The shortfall has to be drawn from the cash value. That’s why the cash value will dwindle fast. When there is no cash value left, the insurance lapses.
Options and a Solution
My client is left with the unenviable options of either:
- Surrendering the insurance and taking out the cash value, which means accepting $131,000 of loss without the benefit of a tax write-off.
- Keep paying the premium and hoping his dad won’t live past 83.
If you truly want to leave something to your children other than financial loss and headaches, try true investment, like a 50/50 portfolio in stock and bond index funds. If my client’s dad had done that, putting $9,000 into such a portfolio every year, he could have left his son with $670,000. (For more, see: Estate Planning for Beginners, Part Two.)
Since my client and his dad cannot go back to the past and start all over again, what can they do to make the situation less bad? Since this is a universal life policy, he could lower the death benefit to $300,000. This could push back the time of insurance lapse to when his dad is 87. He will face the same issue though – his dad has to die before the insurance lapses otherwise all the money they have paid will go down the drain.
The best option is to do a 1035 exchange of this life insurance into a low-cost variable annuity and invest the money in an index fund. The cost basis of the life insurance, i.e $234,000, will be transferred to the variable annuity. As the result, when the value of the variable annuity grows to the cost basis of $234,000, all the gains will not be taxable.
After the variable annuity has recovered the cost basis, it should be cashed out and the money invested in a taxable index fund. This is because while gains in a variable annuity are taxed at the higher income tax rate, whole gains in a taxable index fund are taxed at the lower capital gain tax rate. (For more, see: 3 Simple Steps to Begin Estate Planning.)