The Transferability Myth: Understanding The Non-Negotiable Nature Of Term Insurance Policies

Term insurance is a type of life insurance that provides coverage for a specified period, usually between 5 and 30 years. It is a popular choice for individuals seeking protection during vital financial times, such as paying off a home or raising children. While term insurance offers affordable premiums, it does not accumulate a cash value, and there is no payout if the policy expires before the insured's death. On the other hand, whole life insurance provides permanent coverage until the death of the policyholder and includes a savings component.

In certain circumstances, it may be possible to transfer term insurance to another party or convert it into whole life insurance. Transferring term insurance to someone else can help beneficiaries avoid estate taxes, but it requires careful consideration of IRS rules and potential gift taxes. Converting term insurance to whole life insurance is an option offered by some insurers, allowing policyholders to extend their coverage indefinitely, although premiums will increase.

Transferring ownership to avoid taxes

Transferring ownership of a life insurance policy to another person can be a way to reduce estate taxes. However, it is important to carefully consider the implications and seek professional advice before transferring ownership. Here are some key points to keep in mind:

Timing of Transfer

The timing of the transfer is crucial. If you transfer the policy and pass away within three years of the transfer date, it will still be considered part of your estate for tax purposes. Therefore, it is advisable to transfer the policy sooner rather than later, especially if your health is a concern.

"Incidents of Ownership"

According to the IRS, if you retain any legal rights to the policy after the transfer, such as the ability to switch beneficiaries or borrow against the policy, you are still considered the owner for tax purposes. This could result in the estate tax being applied even after the transfer.

Gift Taxes

Transferring a life insurance policy with a cash value to someone else may trigger gift taxes if the value exceeds the annual exclusion limit. In 2022, the limit was $16,000, and it is $18,000 in 2024. However, it is important to note that the gift tax will typically be much lower than the estate taxes that would be owed if you kept the policy in your name.

Transfer-for-Value Rule

It is important to be aware of the transfer-for-value rule. This rule states that if a life insurance policy is transferred for something of value, the death benefit may become partially or fully taxable. This rule was established to prevent people from reaping large tax-free windfalls by transferring policies between parties.

Transferring to Spouse vs. Other Family Members

When considering who to transfer the policy to, it is worth noting that transferring it to your spouse could result in high estate taxes. Transferring the policy to an adult child or another relative may be a better option for minimizing tax liability.

Seeking Professional Advice

Transferring a life insurance policy to avoid taxes can be complex, and there may be other factors to consider, such as the structure of the policy and your specific circumstances. It is highly recommended to consult with a financial advisor, tax advisor, or attorney to ensure you make the best decision for your situation and to avoid any unintended consequences.

Understanding the transfer-for-value rule

The transfer-for-value rule is a provision in the U.S. tax code (IRC Section 101(a)(2)) that addresses the taxation of death benefits when a life insurance policy is transferred for valuable consideration. Under normal circumstances, life insurance death benefits paid to beneficiaries are generally income tax-free. However, if a life insurance policy is transferred to another party for valuable consideration, the death benefit may become partially or fully taxable.

The transfer-for-value rule was created to discourage speculators from transferring life insurance policies between parties to reap large tax-free windfalls.

The rule applies if the policy is received in return for valuable consideration of any kind. The amount of the death benefit that is not taxed equals the value of the consideration received plus any subsequent premiums paid into the policy by the recipient after the transfer. The rest of the death benefit is fully taxable as ordinary income.

There are five exceptions to the transfer-for-value rule:

• Policy transfers to the insured on the policy
• Policy transfers to a partner of the insured on the policy
• Policy transfers to a partnership in which the insured on the policy is a partner
• Policy transfers to a corporation in which the insured on the policy is an officer or shareholder
• Policy transfers in which the recipient's cost basis in the policy being transferred is calculated in reference to the cost basis of the transferor

The transfer-for-value rule impacts life insurance planning. Individuals considering transferring a life insurance policy should be aware of the potential tax consequences. Careful planning and understanding of the tax implications are essential to avoid unexpected tax liabilities.

IRS rules on life insurance transfers

The IRS has rules that determine who owns a life insurance policy for tax purposes when the insured person dies.

Transfers within three years of death

Gifts of life insurance policies made within three years of death are disallowed for federal estate tax purposes and often for state estate tax purposes, too. In other words, if you pass away within three years of transferring your life insurance policy to someone, the proceeds are included in your estate as if you had remained the owner of the policy.

Incidents of ownership

Another IRS rule states that a deceased person who kept any "incidents of ownership" of a transferred life insurance policy is still considered the owner. "Incidents of ownership" is legal terminology for significant power over the transferred insurance policy. The proceeds of the policy will be included in your taxable estate if you have the legal right to:

• Change or name beneficiaries of the policy
• Borrow against the policy, pledge any cash reserve it has, or cash it in
• Surrender, convert, or cancel the policy
• Select a payment option—that is, decide if payments to the beneficiary will be in a lump sum or in instalments

Transfer-for-value rule

The transfer-for-value rule states that once the recipient of a life insurance policy transfers the benefit to another party, the tax-exempt status of the policy is removed and the purchaser has to pay income tax on a portion of the death benefit. The rule applies if the policy is received in return for valuable consideration of any kind. The amount of the death benefit not taxed equals the value of the consideration received plus any subsequent premiums paid into the policy by the recipient after the transfer. The rest of the death benefit is fully taxable as ordinary income.

Gift tax when transferring life insurance

If you give a permanent life insurance policy to another person, including a beneficiary, the IRS regards the transaction as a gift. That means that, depending on the policy's worth, the transfer could be taxed. Because term life insurance policies don't have a cash value, transferring one won't trigger a gift tax—but it could trigger an estate tax.

Term insurance conversion to whole life insurance

Term life insurance provides coverage over a limited number of years, while whole life insurance covers the policyholder until death. It is possible to convert a term policy into a whole life policy, but not vice versa.

Reasons to Convert Term Insurance to Whole Life Insurance

• Change in health: If your health has changed for the worse, converting your term insurance to whole life may be a way to get permanent insurance without subjecting yourself to an entirely new policy or another physical exam.
• Need for cash value: Many policyholders enjoy the cash value component of whole life insurance. Whole life insurance takes a portion of your premiums and puts it towards building cash value. Some policyholders can take advantage of this cash during retirement, tax-free. Others can borrow against the cash value during financial emergencies.
• Increased budget: Over time, your income may have increased, allowing you the new opportunity to invest in whole life insurance. If permanent life insurance fits better into your budget now than before, it may be time to convert.

How to Convert Term Insurance to Whole Life Insurance

• Confirm your policy is transferable: While most policies include a clause around conversions, you'll need to confirm that your term policy is transferable into a whole life policy.
• Check the term conversion period: The term conversion period refers to the time frame when your term policy is eligible for conversion to whole life insurance. While some policies may allow conversion at any time, others may restrict conversion periods.
• Contact your insurance agent: If your policy is transferable and you're within the conversion period, you would next call your insurance agent to formally request the conversion.
• Complete the documentation: An insurance specialist will send you a questionnaire to fill in a few details, and within a few days, you'll soon receive the new permanent policy.

Factors to Consider Before Converting

• Cost: There are no fees to convert a term policy into a whole life policy; however, your premium will increase, meaning higher payments. Premiums are generally higher with whole life insurance, and your age will also be a factor.
• Conversion amount: Another aspect affecting cost is how much of your policy you convert – you can choose between the full value or a portion of it.
• Policy conversion rates: Some insurers give policyholders a credit for the amount they've paid towards their term life insurance. This credit goes towards their new whole life policy.

Advantages and disadvantages of term life insurance

Term life insurance is a temporary insurance policy that covers a fixed span of time. It is generally considered more affordable than whole life insurance, but it does not accumulate cash value. Here are some advantages and disadvantages of term life insurance:

Advantages

• Cost-effective: Term insurance plans are one of the most cost-effective types of life insurance. Policyholders can obtain large life coverage at affordable premium rates, making it a favoured option for many.
• Large Sum Assured: With term plans, individuals can secure a high sum assured at affordable premiums.
• Rider Benefits: Term insurance rider benefits allow policyholders to enhance their coverage by increasing the policy cover at nominal premiums. By adding riders, individuals can obtain coverage against critical illness, terminal illness, accidental death, accidental total permanent disability, hospicare, and waiver of premiums.
• Flexibility: Term insurance plans offer flexibility in terms of renewability and convertibility. Policyholders can renew their plans without undergoing additional medical examinations, and they also have the option to convert their term plans into endowment plans.
• Easy to Buy: It is simple to compare the premiums and benefits of term insurance plans offered by different insurers, making it easy to select the most suitable plan for an individual's needs.
• Simple: Term insurance plans are generally simpler than other life insurance products, such as money-back plans or endowment plans. With a term insurance plan, individuals pay the premium and obtain life coverage for the selected term.
• Flexible Claim Payout: Term insurance gives policyholders the option to choose how the sum assured will be paid to the nominee after their death, either in a lump sum or in instalments.
• Tax Benefit: Depending on the jurisdiction, individuals may be able to claim tax benefits on their term insurance plans.

Disadvantages

• No Investment Opportunities: Term insurance does not offer investment components or maturity benefits. It is designed solely to provide death benefits, with some plans including survival benefits.
• No Assistance When Alive: Term insurance plans do not provide financial assistance to policyholders during their lifetime.
• No Survival Benefit: In the case of a regular term insurance plan, if the policyholder outlives the policy tenure, they will not receive any survival benefit. However, in the case of a term return of premium plan, the entire premium amount paid throughout the policy tenure is returned if the policyholder survives.
• Increasing Premiums: Premiums for term life insurance tend to increase as the policyholder ages. Renewing a policy later in life, such as in one's 50s or 60s, can be significantly more expensive than purchasing it earlier.

Frequently asked questions