Dumping Whole Life Insurance: Strategies For Policyholders

Whole life insurance is a type of permanent life insurance that combines an investment with traditional life insurance. It is often sold, not bought, and many people who own it don't know why they have it. Whole life insurance is a poor investment choice because of its low returns, especially in the first few years. It is also inflexible, requiring ongoing payments, and has high fees and commissions.

If you are considering dumping your whole life insurance policy, you should first determine whether you want or need a permanent life insurance policy. If you do not, you can simply cancel the policy. If you have had the policy for a long time, you may want to keep it as the terrible returns are heavily front-loaded.

If you decide to cancel your whole life insurance, you should do it as soon as possible. You can exchange your whole life insurance policy for another one, such as a modified endowment contract, or a variable annuity, which can help you preserve any losses for tax purposes. You should also consider the alternative investment options available to you and compare the policy's merits against them. Finally, make sure you have sufficient term life insurance in place before cancelling your whole life insurance policy.

Consider the alternatives

Before dumping your whole life insurance, it is important to consider the alternatives. Here are some options to think about:

• Keep the policy if you need permanent life insurance: If you will never be financially independent, always have someone depending on your income, have an estate tax problem, a liquidity problem, or some legitimate business issues that are best solved with these policies, you may want to keep your whole life insurance policy.
• Keep the policy if you've had it for a long time: Whole life insurance has low returns when held for decades, but the returns going forward may not be too bad if you've passed the first 15-20 years.
• Get term life insurance first: Before cancelling your whole life insurance, make sure you already have sufficient term life insurance in place to meet your needs.
• Evaluate your options carefully: If you have paid tens of thousands of dollars in premiums, spend some time deciding what to do with the policy. You may be able to avoid taxation on gains by exchanging it for a better cash value life insurance policy, a very low-cost variable annuity, or long-term care insurance.
• Consider a 1035 exchange: If you have a loss on your policy, you can do a 1035 exchange to preserve the loss for tax purposes. This involves exchanging the cash value into a low-cost variable annuity and waiting for the value to equal the basis before surrendering the annuity with no tax due.
• Swap your policy for another one: You can exchange your whole life policy for a different type of permanent life insurance policy, such as a single premium universal life policy. This option may provide a larger death benefit and no more payments, but there is a risk of having to start making payments again in the future, and you may lose the ability to borrow from the policy tax-free.
• Use whole life insurance for asset protection: In some states, whole life insurance policies are protected from creditors, which can be appealing if you are concerned about asset protection.

Get term life insurance in place first

Getting term life insurance in place before dumping your whole life insurance is a crucial step to ensure that you have sufficient coverage to meet your needs and wants. Here are some detailed instructions and considerations to help you through the process:

Understand the Differences Between Term and Whole Life Insurance:

Term life insurance is a type of coverage that provides a death benefit for a specified period, such as 10, 15, or 20 years. It is usually the most affordable option and does not have a cash value component. Whole life insurance, on the other hand, covers you for your entire lifetime and often includes fixed premiums and a cash value that can grow over time.

Evaluate Your Needs and Goals:

Consider your current financial situation, including your income, expenses, and future goals. Term life insurance is ideal if you want substantial coverage at a lower cost, especially if you are young and healthy. Whole life insurance, on the other hand, may be preferable if you want lifelong coverage and are willing to pay higher premiums.

Shop Around for Term Life Insurance:

Compare quotes from multiple insurance companies to find the best rates and coverage options. Look for insurers with strong financial strength ratings, indicating their ability to pay claims in the future. Also, consider the application process, policy features, and customer service when choosing a provider.

Choose the Right Term Length:

Term life insurance policies are available in various increments, typically ranging from 10 to 30 years. Consider how long your loved ones will need financial support, such as covering major expenses like a mortgage, childcare, or future goals like college tuition.

Determine the Coverage Amount:

Calculate how much coverage you need by considering your current financial obligations and future goals. Subtract any assets you already have, and the remaining amount is the gap that term life insurance can help fill. Most companies offer coverage starting at $100,000, but you can choose a higher amount based on your needs.

Consider Additional Riders:

You can customize your term life insurance policy with riders, which provide additional benefits. For example, an accelerated death benefit rider allows you early access to the death benefit if you become terminally ill, while a waiver of premium rider pauses your premiums if you become disabled and can't work.

Complete the Application Process:

Provide accurate information about your health, lifestyle, and medical history during the application. Be prepared for a medical exam, which may include blood tests, urine samples, and measurements of your vital signs. The insurance company will use this information to determine your final premium and coverage amount.

Remember, it is essential to have adequate coverage in place before canceling your whole life insurance policy. Take the time to research and compare term life insurance options to ensure you make the best decision for yourself and your loved ones.

Don't worry about tiny policies

When you start talking about getting rid of a policy, the first thing to consider is any possible tax penalties or tax benefits of doing so. For a teeny, tiny policy like the one I had, that just doesn't matter much. My loss was only a few hundred dollars, and the tax benefit on that would be far outweighed by the hassle factor and the actual costs to claim that. If you have a tiny whole life policy, just cancel it.

You may have had one of these purchased for you by your parents, who dutifully paid a few bucks a month on it for two or three decades before presenting all $2,000 of cash value in it to you (and asking you to take over the payments). Be sure to thank them for their thoughtfulness, then cash it out and use the money to fund a Backdoor Roth IRA. You might not want to mention that you did that during Thanksgiving dinner, by the way.

Evaluate your options carefully on a large policy

If you have paid tens of thousands of dollars in whole life premiums, you should spend a little more time deciding what to do with your policy. If your policy has a large gain, you've probably had it long enough that you should keep it. But if not, you can avoid taxation of that gain (typically taxed at your regular marginal tax rate) by exchanging it into a better cash value life insurance policy, a very low-cost variable annuity (VA), or even long-term care insurance.

The best of those options, in my view, used to be the VA, since buying another cash value life insurance policy most likely entails another fat commission, and most doctors reading this site ought to eventually be able to self-insure any long-term care needs. However, it is not so easy anymore to find a low-cost VA, so even that isn't a great option for a policy with a gain. Unfortunately, you can't even use losses from tax-loss harvesting to offset the gains since gains in a life insurance policy are not considered capital gains.

A much more likely scenario for someone who has only been paying premiums for a few years and now realizes they bought a “pig in a poke”, is that you are way underwater on your “investment” at this point. Perhaps you've been paying premiums of $20,000 per year for five years, and now have a cash value of $75,000. You could just surrender the policy, take your $75K to invest elsewhere, and consider the $25K a “stupid tax”. Or, you could have Uncle Sam share your pain a little bit.

One way to preserve this loss for tax purposes is to do a 1035 exchange. You must have at least $1 in surrender value to do this (so maybe make a few more payments if you don't have any cash value at all), but basically, you exchange the cash value into a low-cost VA, if you can find one now that Vanguard has passed its VA business to Transamerica and Jefferson National has been purchased by Nationwide. This exchange not only preserves the cash value tax-free, but also preserves the basis. You can then let the VA grow until the cash value equals the basis, and subsequently surrender the VA with no tax due. Years ago, you could actually immediately deduct losses in a VA (but not a loss in life insurance), but that loophole has been closed now for several years. So if you do this, you'll need to hold the VA for a while (paying its additional expenses) in order to take advantage of some tax-free growth. With an expensive enough VA, even that wouldn't be worth doing.

Another option is to exchange that whole policy into a modified endowment contract. This can eliminate any need for you to make additional payments into the policy, a big reason why people want to dump their policies. Then you simply leave it alone until your death and have it be part of the inheritance you leave your heirs or your favorite charity. Note that if you go down this path, you can't use the cash value for a better use nor can you borrow against the policy later in life.

There are lots of options when you want to cancel your whole life insurance policy. Spend time evaluating them or you may make another mistake almost as big as the one that got you into this mess. But quit beating yourself up about your decision to buy it; many of us have done that.

Exchange your whole life insurance policy for a modified endowment contract

A modified endowment contract (MEC) is a life insurance policy in which the cash value component has been overfunded per IRS guidelines. In other words, a life insurance policy is labelled an MEC when a policy's cash value grows too quickly.

Passed by Congress in 1988, the Technical and Miscellaneous Revenue Act (TAMRA) introduced MECs to curb individuals from treating life insurance products as an investment vehicle and tax shelter. Furthermore, Internal Revenue Code (IRS) Section 7702 provides details regarding the taxation of life insurance, and Section 7702A defines MEC status.

Compared to a regular life insurance policy, an MEC provides fewer tax benefits. While the death benefit of an MEC remains tax-free, the gains from policy loans, withdrawals and surrenders are subject to income tax.

Additionally, if you withdraw cash value before the age of 59 and a half, you might owe a 10% penalty on the gains. This treatment is similar to that of a non-qualified annuity.

Term life insurance, which is one of the most affordable types of life insurance products, cannot become an MEC because it doesn’t accumulate cash value.

The IRS utilises something called a seven-pay test to determine if a life insurance policy is considered an MEC. This test, applied over a policy’s first seven years, looks at whether the accumulated premium payments exceed the total amount required to pay the policy within those seven years. If a life insurance policy fails the test, it becomes an MEC.

Say you have a whole life insurance policy with a death benefit of $500,000. In this case, your seven-pay premium limit would be $5,000 per year. Assume you pay the following amounts into your account over seven years:

• $5,000 each of the first three years your life insurance policy is active
• $6,000 per year in years four and five
• $5,000 per year in years six and seven

Because you overfunded your life insurance policy during years four and five, you would fail the seven-pay test and your life insurance policy would be classified as MEC.

Insurance companies try to warn you about the seven-pay test through an illustration in your life insurance contract. For this reason, it’s important to read your life insurance contract and illustration and consult with an experienced financial advisor when structuring premium payments.

The primary benefit of an MEC is the potential for higher cash value accumulation due to overfunding. This increased cash value can serve as a financial resource, providing funds for retirement, education, estate planning or other major expenses.

With an MEC, the death benefit paid to a policy owner’s named beneficiaries remains tax-free. Also, benefits paid by your life insurance policy for a chronic illness, critical illness or long-term care benefit are received tax-free because they are considered an acceleration of your death benefit.

MECs come with significantly fewer tax advantages than traditional life insurance policies.

In general, MECs require you to make withdrawals on an income-out-first basis, which means you have to withdraw taxable gain income before withdrawing tax-free principal payments. In other words, your first withdrawals from your cash value will be taxable, assuming you have taxable gains in your cash value account.

In addition, withdrawals made before the age of 59 and a half are subject to a 10% penalty on the gains, which can erode the cash value over time. Policyholders should also note that transforming a life insurance policy into an MEC is irreversible under current tax laws.

Avoiding an MEC primarily involves careful structuring of your policy’s premium payments. Here are a few strategies to consider:

• Adhering to the seven-pay test: Ensure that your premium payments over the first seven years do not exceed the limit defined by the IRS’s seven-pay test. The specific limit varies based on your policy’s death benefit, age and other factors.
• Multi-year funding: Consider spreading out cash value funding over several years instead of making a large, lump-sum payment, which could potentially trigger the seven-pay test.
• Regular review of the policy: You can regularly review and adjust your policy payments to prevent overfunding. For more information, inquire with your insurance provider about the current status of your policy and whether it is close to becoming an MEC.

You can’t reverse MEC status. Once a policy is classified as an MEC, it cannot be turned back into a traditional life insurance policy.

However, if you have an MEC and wish to have a policy that functions like traditional life insurance, you may consider purchasing a new life insurance policy and surrendering the MEC. In this case, it is important to discuss potential tax consequences with a personal financial advisor.

Most insurance companies provide warnings and in some cases automatic triggers, to prevent you from unintentionally turning your permanent life insurance policy into an MEC. Here are a few things many insurance companies do to help:

• Send you written notices making you aware of the potential issue
• Provide options to correct the issue if it was done in error, however, you may have a very short time window to do so
• Automatically force cash value out of your life insurance policy. Some life insurance companies will automatically send you a refund check if they do not receive prior written authorization that you intend to create an MEC.

Keep in mind that while these strategies can help prevent your life insurance policy from becoming an MEC, everyone’s financial situation is unique. It’s important to consult with a professional to determine the best course of action for your specific needs.

Frequently asked questions