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December 4, 2012

Are there better uses for cash values within a life insurance policy or if the policy is no longer need?

There seem to be an increasing number of articles about these issues relating to cash value insurance policies.  This discussion is not applicable to term insurance.  Cash value life insurance policies have a cash value in addition to its death benefit.  The amount of the cash value is funded by a portion of the premiums and the earnings net of expenses over the period that the policy is in force.

Over a long period the cash values within a life insurance policy may be significant.  You can access the cash by taking withdrawals some of all of the funds.   If the amount withdrawn is less than the premiums you paid, less any prior withdrawals, there are not any tax consequences from the withdrawals.  Otherwise the excess amounts will be taxed at ordinary tax rates.

An alternative would be to borrow some or all of the cash values.  Life insurance coverage is reduced by the amount borrowed and interest on the amount borrowed.

The earning on the cash values can also be used to pay premiums.

If the life insurance is no longer needed there are various alternatives.  It is possible to exchange a life insurance policy for an annuity or a long-term care policy.  This can be done without recognizing taxes on your gains.  If the value is more than the premiums paid less any prior withdrawals.

The issues are different if the premiums paid, less prior withdrawals, are more than the cash values.   The loss on surrender or sale of the policy would not be tax deductible.  Alternatively the policy could be exchanged for an annuity.  The loss in the policy would still not be deductible.  However, the loss would reduce future gains in the annuity.  Ellen E. Schultz’s November 3oth article in The Wall Street Journal, “Insurance Can cut Your Taxes” discusses this issue in more detail.

These alternatives must be considered in relation to you complete financial plan.  No one approach applies to every situation.  Among the factors to consider are: the amount of coverage needed, the returns within the policy compared to alternative returns available and the tax consequences.   An understanding of the alternatives and related consequences must be understood.
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