There Are Only Three Reasons to Own Life Insurance

Q: Does it make sense for me to keep paying for a life insurance policy now that I'm 67 years old, my kids are grown and my mortgage is paid off? --OR, via email

A: Maybe not. At the very least, it's sensible to reassess your insurance needs at this stage of life, especially if you own a permanent policy -- a combination of a death benefit and a tax-deferred investment.

There are three basic reasons to own life insurance:

A) To replace your salary for your dependents when you die.

This is crucial when you're a breadwinner with a young family. If this is your reason to own life insurance, your best purchase is a term policy -- insurance with no investment component -- because it provides the biggest death benefit at the smallest cost. Permanent policies are much more expensive. The cost of term insurance rises as you age, but even in your 50s it's often the cheapest coverage available.

B) To make sure your heirs have cash to pay your estate taxes. 

Few people have to worry about how their survivors will pay estate taxes, because most people don't leave taxable estates. There is no estate tax on the assets you leave to your spouse. And under current law, what you leave to everyone else isn't subject to federal estate tax unless its value exceeds $5 million. True, the current law expires in 2013. And some states impose a tax on smaller estates. New York's estate tax law applies to estates worth more than $1 million, for example.

But even if your estate is taxable, buying life insurance to pay the taxes isn't a no-brainer. If the estate includes liquid assets, you might decide to let your heirs pay the taxes out of their inheritance. On the other hand, you may want to consider a life insurance policy if your survivors would be unable to pay the estate taxes without selling your business or taking taxable withdrawals from your IRA. 

(One caveat: If you want life insurance to pay your estate taxes, you must not own the policy yourself. A policy intended to pay your estate taxes should be transferred to another person or to an irrevocable life insurance trust -- after you've consulted a tax professional to make sure the transfer won't inadvertently trigger gift or income taxes.)

C) To invest on a tax-deferred basis.

If your kids are grown and your other assets are sufficient to provide for your surviving spouse, this is the main reason for still owning life insurance. 

So how good an investment is it?

That depends on your policy, says Richard Freeman, a fee-only financial planner at Round Table Services in Westport, Connecticut.

When you bought it, you saw a policy illustration showing how your investment (or cash value) would grow. But the illustration was a marketing tool, not a guarantee. Here's Freeman's explanation of how permanent insurance works:

Your premiums go into an investment box, from which the cost of insurance and expenses is deducted every month.

If things go worse than expected -- if the cost of insurance and expenses rises more than anticipated, for example, or if the investments underperform because, say, the financial markets crashed -- one of three things will happen: You'll have to pay higher premiums, or take a lower death benefit, or you won't be able to pull as much cash out of the policy as you expected.

If things go better than expected, you'll have the option to pay smaller premiums, or to increase your death benefit, or you'll have more cash to tap.

To find out how your policy is performing as an investment, you need an objective appraisal by someone who understands insurance but isn't paid to sell it -- i.e., not an agent. If your policy represents a substantial investment, it's worth paying a fee-only adviser like Richard Freeman or Glenn Daily for an in-depth analysis and assessment of your options. (One choice that sometimes makes sense, for example, is to exchange your life insurance policy for an annuity.) Fee-only advisers typically charge $200 to $300 per hour. If your policy isn't big enough to justify that expense, a much simpler but equally objective assessment from the Consumer Federation of America (CFA) will cost you only $85.  

Please send your questions to [email protected].  I'm sorry I can't respond personally to every email. Questions are only addressed online.

(c) Lynn Brenner, All Rights Reserved

Comments

[Michael Ross, CFP®]

I would amend section A to include lost income not just salary. That could also include business investment and pension income. Any income that would decline or stop upon death should be considered in this calculation.