Many of our clients who bought cash value life insurance policies are taking a hard look at their policies in light of changed circumstances or a changed planning environment. Whether it's because of personal cash flow issues, reassessment of the underlying coverage needs, or gift or estate tax considerations, clients sometimes ask advisors what to do with their policies.

Two common situations demonstrate the ways in which planners are being called upon to help clients make some pretty tough decisions. In one, the insured person believes he doesn't need the coverage anymore and wants options for turning the policy into cash. In the other, the insured has an irrevocable life insurance trust (ILIT) and needs the coverage, but is having difficulty paying premiums, either because of cash flow or because gifts of premium to the ILIT are now generating gift tax.

There are answers. In the first type of situation, the client (let's call him Jack) can surrender the policy outright, make partial surrenders or withdrawals, exchange his policy for a variety of annuities, or make a life settlement. In the second situation, the client (let's call her Sue) can take a variety of “reduced paid-up” approaches, exchange the existing policy for a new one and, in the right circumstances, coordinate use of a life settlement with a policy exchange.

JACK'S STORY

Jack is 73 years old and, depending on when you ask him, fairly healthy. He bought a $1.5 million cash value life insurance policy many years ago. He might have needed the insurance for family security, estate tax liquidity or some other reason. But times have changed, and Jack thinks he doesn't need the coverage anymore. He is also a little tired of paying those premiums.

Jack has paid $200,000 in premiums over the years, which is his basis in the policy for tax purposes. The cash surrender value in the policy is now $300,000. He is inclined to just surrender the policy and invest or spend the proceeds. He wonders, though, if some other option might offer him more attractive economics.

In fact, Jack has several options, depending upon his facts and circumstances. He certainly can surrender the policy for its cash value. The $100,000 of cash surrender value over the total premiums he paid over the years would be ordinary income to him.

But Jack doesn't have to surrender the policy to turn it into cash, or have it generate a cash flow. One of the most attractive features of cash value life insurance is the ability to access the cash value on a tax-free basis. Depending on the type of policy he has, Jack can take tax-free partial surrenders of additions (whole life) or partial withdrawals (universal life) up to his basis. Thereafter, Jack can take tax-free policy loans from the cash value. The insurer will charge interest on the loan, but Jack doesn't have to pay the interest currently. He can allow the interest to accrue on the loan so that the loan and accrued interest will be repaid (netted out from the death benefit) when he dies.

Jack's insurance agent can show him illustrations that depict a variety of approaches for tapping the cash value for a tax-free income stream. Jack will see that as he takes down the cash value, the death benefit will drop as well. But Jack doesn't think he needs the insurance coverage anymore, so that's fine with him. The only thing he has to be careful about is that if he borrows so much from the policy that it can't support a death benefit anymore, the policy will lapse and he would have a lot of taxable income but no cash to pay the tax. Therefore, Jack's agent should monitor the policy for him to make sure each new loan is supported by the policy.

His agent can also show him some other options. For example, Jack can exchange the policy for an immediate annuity. The exchange would be tax-free under Internal Revenue Code Section 1035 and the insurer would start paying Jack an income stream right away.

If Jack buys an immediate annuity, the income stream could be based on his life alone or on the joint lives of Jack and his wife, (you guessed it) Jill. Jack will carry the $200,000 basis he had in the life policy over to the annuity. Until that basis has been fully recovered, each annuity payment is comprised of a tax-free return of basis and an ordinary income portion. The portion of each payment that is returned free of tax is determined by an exclusion ratio, which is determined by dividing the investment in the contract by the expected return or the aggregate fixed annuity payments that Jack can expect to receive under the contract.

So, let's assume that Jack exchanges his life policy for an annuity that will pay him $27,000 per year for the rest of his life. Based upon his investment in the contract, the amount of the annuity and his life expectancy, 50.7 percent of each payment (the exclusion ratio) will be tax-free. However, the entire annuity payment will be ordinary income once Jack has received $200,000 in payments. If Jack's health is not that good, he might qualify for a “substandard” annuity, which would generate a considerably higher payout from the insurer.

Jack's agent will help him and Jill determine whether it makes more sense (and generates more after-tax dollars) to tap the life insurance policy for income or exchange it for an annuity. Of course, Jill will gently nudge Jack in the direction of an annuity that has a survivor benefit.

If Jack is charitably minded, he might consider donating the policy to a charity in exchange for a charitable gift annuity. The charitable gift annuity allows Jack to provide a gift to charity in exchange for an annuity. Jack can transfer the policy to, let's say, a museum, which will agree to pay him a guaranteed specific quarterly income for life. The amount of each annuity payment will depend upon the value of the policy and the annuity rate, which is set by the American Council on Gift Annuities.

The Council changes these rates periodically to reflect current mortality, interest rates and other factors. Generally, the rate is intended to result in a remainder to the charity equal to 50 percent of the amount contributed. Currently, the annuity rate for a 73-year-old is 6.8 percent. Therefore, if Jack gives the policy to the charity in exchange for a gift annuity, he will be entitled to an income stream of $20,400 a year for the rest of his life. Again, Jill might remind Jack to explore a two-life annuity.

The income tax consequences of this transaction are that Jack is entitled to a current income tax charitable deduction based in part on the total amount of premiums he paid on the policy. He will be taxed just as he would be on any annuity payment. While it's likely that the commercial (insurance company) annuity will offer a higher payout than the charitable gift annuity, Jack may be sufficiently charitably inclined (and financially comfortable) to prefer taking the philanthropic route.

Another option for Jack is a “life settlement.” Life settlements are having a major impact on estate, financial and insurance planning. Individual policyholders need to understand them — or at least know they are out there. Estate planners need to understand them too. Trustees of life insurance trusts certainly need to be aware of them, even if the grantor/insured of that trust still needs coverage. And we all need to know how to get the client the best deal in these transactions. Don't be surprised to see more life settlements as people realize that their balance sheets and income statements are losing the race against longer life expectancy.

In a life settlement, Jack sells his policy to a third-party, the life settlement company, for a lump-sum cash payment. A life settlement can yield a policyholder a sum considerably more than the amount he would receive by simply surrendering the policy. Unlike viatical settlements, which involve policies on the terminally ill, life settlements involve the purchase of policies on people with life expectancies of 12 to 14 years or less. The settlement company may hold the policy until Jack passes away or it might resell the policy in an after-market.

The life settlement company will consider much more than Jack's age (a male over age 79 and a female over age 82 is generally considered “good.”) and actuarial life expectancy in formulating its offer to Jack. It also will consider (1) whether Jack's health has worsened since his policy was issued; (2) whether he is a smoker (a smoker is, ironically, better); (3) whether there are any policy loans (better if there aren't); (4) the ratings of the insurance company that issued Jack's policy; (5) the type and structure of the policy; and (6) how much it will cost to maintain the policy until Jack is projected to pass away. The shorter his life expectancy and the less premium required to support the policy, the higher the life settlement's offer will be.

But, while Jack will have to provide a certain amount of information about the policy and a good deal of information about his health, he won't have to have a medical examination or blood tests.

The tax treatment of a life settlement is unsettled. One point of view is that the settlement proceeds up to basis are received tax-free, the excess of the proceeds up to the remaining amount of cash value are ordinary and any excess of proceeds over the cash value is capital gain. But there is no official guidance on the matter, and the Internal Revenue Service might consider all of the settlement proceeds in excess of the basis as ordinary income.

If Jack is intrigued by the life settlement concept, his agent can initiate the process and eventually solicit bids from several companies. Depending on Jack's state of residence, his agent may have to be specifically licensed to be involved in life settlement transactions. Jack should press the agent to get — and tell him about — offers from several life settlement companies. He also should insist on full disclosure of the total compensation (including the agent's commission) on each offer. The compensation is usually 6 percent of the face amount of the policy, split between the agent and the life settlement broker, but will vary depending upon the case (size of offer, size of policy etc.). In any event, the commission should be negotiable.

Each alternative brings something to the table for Jack to discuss with Jill, their financial planner and insurance agent. This is one of those decisions made as much with the gut as it is with the spreadsheet. If Jack really just wants all of the cash now, he'll surrender the policy or, if he is comfortable with a stranger owning a policy on his life, sell it in a life settlement transaction.

But the investor in Jack might well look at the level death benefit of the policy and figure that he just might be able sell the policy and invest the proceeds of the life settlement well enough to leave a larger amount of money to his survivors than if he'd kept (and kept paying premiums on) the policy. In this case, the planner would determine the lowest premium outlay projected to support the death benefit comfortably beyond Jack's life expectancy and then compare on an annual basis, the “premium-cost-adjusted” death benefit from the policy to the after-tax result of investing the (after-tax) proceeds of the life settlement. Depending upon the facts and assumptions, Jack might see, for example, that it'll take 10 years for the life settlement to result in more capital for his family. Once that “crossover” occurs, however, the life settlement will win by an ever increasing margin. So, if Jack knows when he is going to die and how much he can make on his money, the decision is easy. Otherwise, it is decidedly not. Maybe Jack (and Jill) might just decide to hold on to the policy, cut the death benefit back a bit, take some income from the policy and leave a residual amount of insurance. In any case, it should be an interesting discussion.

SUE'S STORY

Jack's neighbor Sue also bought a cash value policy sometime ago. Actually, the $5 million policy is owned by her irrevocable life insurance trust. Sue, who is 77 and not particularly healthy, still needs some coverage for estate taxes. But her investment income is down these days and she's concerned about making significant annual gifts of premium to the trust each year. Sue wonders if there is anything she can do reduce her outlay while still maintaining a reasonable amount of coverage.

First, her insurance agent can show her an option called “reduced paid-up” coverage or variations on that theme. If the policy is whole life, the insurer will essentially apply the cash value as a single premium on a reduced amount of fully paid coverage. If the policy is participating, it will continue to receive dividends that, if reinvested in the policy, will purchase more insurance. If the policy is universal life, the agent will ask the insurer to illustrate a reduction in the death benefit to the largest amount that can be supported with no further premiums at conservative assumptions for credited interest and costs-of-insurance.

After reviewing these illustrations, Sue may tell the agent that she can afford to pay something every year, so perhaps the death benefit doesn't have to be cut so drastically. In this case, the dividends on a whole life policy can be applied first to reduce the premium and Sue will make gifts to the trust of the presumably ever-decreasing difference between the premium and the dividend. With a universal life policy, the insurer would illustrate the largest amount of death benefit that can be supported at Sue's acceptable outlay, again under conservative assumptions. Eventually, Sue would arrive at a comfortable balance between premium outlay and the longevity of the death benefit.

Another option would be for the trust to explore a tax-free exchange of the current policy for a new policy. Although Sue is older than she was when she took out the existing policy, it may well be that, with good underwriting, a modern policy with a flexible premium design and lower internal charges than her existing policy might support the current death benefit at either no further outlay or at least, at a more acceptable outlay for Sue. The agent will have to get updated medical information on Sue and check the marketplace for policies that would make the exchange worthwhile under reasonable assumptions.

Another strategy Sue could consider is a life settlement followed by the purchase of a new policy. Given Sue's age and health, and depending on the status of her policy, a life settlement company might offer Sue considerably more than the cash surrender value of her policy. If the ILIT is a grantor trust for income tax purposes, Sue (and not the ILIT) will pay the tax on that gain. If that result, meaning Sue gets a tax bill but no cash, isn't itself a showstopper as far as Sue is concerned, the life settlement would enable the ILIT to put far more into the replacement policy than it could have with a pure, tax-free exchange. Sue's financial planner will have to work with her, the trustee and the agent to evaluate the tax and economic implications of this coordinated transaction. If Sue is willing and able to pay the tax on the settlement proceeds and she allows the ILIT to re-deploy the proceeds into a new policy, this strategy may be an attractive one for her.

BE READY

Planners will have more clients like Jack and Sue. More people will believe that they'd rather have the cash for themselves today than all of that insurance for their family tomorrow. And, more people will have to deal with the implications of lower yields on their insurance policies and investment portfolios. Fortunately, the inherent flexibility of today's life insurance products, the ability of agents to match life and annuity products with particular client needs, as well as the existence of a robust life settlement market offer resourceful planners an array of options for most of the situations they're likely to encounter.

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Jean-Michel Basquiat: “Low Pressure Zone,” painted in 1982 and mounted on tied wood supports, sold for $2.2 million at Sotheby's “Contemporary Art” auction in New York on May 12, 2004.