1) I am the owner of a whole life policy through Northwestern Mutual. I have owned it since 1999 and have approximately 22K in cash value. Given the low interest environment these days, I think it might be wise to keep the policy (worth $100,000 in death benefit). Should I decide in the future that it is not worth it, and should I want to avoid taxes, what do you think of a 1035 exchange to LTCI or SPIA? Or would a loan against the policy be a good option or just paying the taxes?
2) I just recently took over a NWM “65 Life” whole life policy. The policy was opened shortly after I was born, and is now about 28 years old. Now that I am making the payments, I have been doing a bit of research on the topic of how to use / what to do with a whole life policy. It is a 65 Life policy and now has a death benefit of $25,383, a cash value of $4368, and an annual premium of $103. I could probably do better with a term policy in terms of coverage, but again I don't THINK I really need it. I don't urgently need the cash for anything. If I did cash out the policy, I'd finally go start a Vanguard account and get an IRA rolling or maybe put some extra $ on the mortgage. At this point if I wanted to surrender the policy, are there any tax implications and what would be the best way to cash the policy out?
This is a common situation for doctors (and others) to be in, thanks to highly motivated whole life salesmen. There is little reason for a physician to own such a tiny policy. If you're going to own a whole life policy (and you probably shouldn't) it should be a much bigger policy than this one. You should be maxing out all available retirement plans and STILL have a large chunk of income you want to save in one of these things (but not too large, since you don't want it to dominate your portfolio nor cause any difficulty paying premiums). For this reason, most doctors simply don't make enough money that there is any great advantage in buying a typical whole life policy.
Northwestern Mutual, in particular, seems to sell a lot of these small policies. I was sold one of my own as a medical student, with a $20K benefit, which I cashed out at a loss after 7 years. To make matters worse, these policies usually aren't set up to maximize investment return, such as it is (generally 2-5% nominal per year when held for 3+ decades.)
Simplify Your Life
So, my general advice for most of these tiny policies, especially in the first decade or two, is to simply liquidate them, consider it tuition in the school of hard knocks, and move on. You're not losing any significant life insurance ($100K in the first case, and $25K in the second case pales in comparison to the $1-3M these folks probably need in term insurance) and you're mostly just throwing good money after bad. I certainly don't regret cashing mine out. The first questioner, 14 years into the policy, is probably just breaking even, so there will be no tax consequences at all to just cashing out now. The second questioner, 28 years into the policy, has paid in $103*28= $2884. With a surrender value (read carefully to make sure this is the same as your cash value) of $4368, that leaves $1484 that will be taxable. At a 33% marginal rate, that works out to $490 in tax. It's hard to justify doing much of anything to save such a small amount.
Keep Older Policies
As a general rule, once you've paid into a policy for 1-2 decades, you're past the worst of it. Now you're making a decent return each year, sometimes much better than you can get anywhere with similar safety. For example, the second policy above had an increase in cash value over the last year of $283. So he started the year at $4085, paid $103 as a premium and it is now worth $4368. That's a return over the last year of 4.3%, which is pretty good considering that 5 year CDs are paying 1.5-2% and 30 year treasuries are yielding only 3.77%. Yes, your initial return was pretty lame (I calculate a return of 2.74% per year for the last 28 years, and much worse than that the first decade), but it's not so bad going forward. So if you want to keep either of these policies, I certainly wouldn't feel like it is a rip-off to do so. But if you'd prefer to just simplify your life and cash them out, that's okay too. In the case of the second question, I don't think I'd mention to my parents that I cashed it out; I'd just thank them for their kind gift. Remember when calculating your return that your return is very different from the published dividend. That dividend applies only to the cash value, not to all of the money you're paying in premiums. After a few decades, the numbers are pretty close (but never equal), but for the first decade or two, they are dramatically different.
The 1035 Exchange
Another option for a life insurance policy or annuity that you've held for some time is to exchange it into a different type of insurance policy. Life insurance policies can be exchanged into another life insurance policy, a Modified Endowment Contract (MEC), an annuity, including Single Premium Immediate Annuities (SPIA), or a long-term care (LTC) policy. MECs can be exchanged into other MECs, annuities, or LTC contracts. Annuities can be exchanged into other annuities or LTC contracts and LTC contracts with cash value can be exchanged only into other LTC contracts.
Reasons To Exchange
There are two reasons to do a 1035 exchange. The first is to avoid paying taxes now. For example, if you've paid much less in premiums than the surrender value, surrendering a policy for cash will trigger a tax bill. If you do an exchange instead of cashing it out, you can delay or even eliminate that tax bill. The new policy should be much more attractive to you than the old one for some reason. It may be you don't want/need a whole life insurance policy and you do want/need a SPIA. Or you may simply wish to get out of a high-cost annuity into one with lower fees.
The second reason to do an exchange is to preserve your high basis in the “investment.” For example, if you're 2 years into a whole life policy and have paid $50K in premiums, but the surrender value is only $20K, then you can preserve that loss by doing an exchange. For example, if you exchanged into an annuity, and then the annuity grew to $50K in value, you could then withdraw the entire cash value without a tax bill.
Nuts And Bolts
You can exchange many policies into one policy, the only requirement is that the owner and the insured (or annuitant for annuities) be the same in the new policy as the old one(s). If you have borrowed from the old policy, you should generally pay back the loan prior to doing the exchange, since it will otherwise be considered a taxable distribution. Your new policy will also likely require an application and underwriting. Insurance agents have a serious conflict of interest in getting you to exchange from an old policy to a new one which will generate a new commission for them, so use extreme care when evaluating any 1035 exchange. Discussing the exchange with a fee-only adviser or other neutral, but informed, party would be a good idea.
If You Bought A Lemon, Might As Well Make Lemonade
I don't generally recommend mixing investing and insuring, but if you have already done so, it's time to make some lemonade. That may involve cashing out of a policy, especially early on, holding on to it for the long run and trying to maximize the return, or 1035 exchanging it into a better policy or even a different type of policy. I don't think I'd hold a whole life policy for decades with a plan to exchange it to a SPIA or a LTC policy. I think most doctors and similar professionals probably should self-insure long-term care, and paying for unneeded/unwanted insurance seems very inefficient. If I had a whole life policy with very low basis (or very high basis), and knew that I would eventually want to purchase a SPIA with that money, I'd probably exchange it into a very low cost annuity such as Vanguard offers, and then exchange it again into a SPIA at retirement time. This approach would eliminate the need to make annual payments, decrease costs, and (most likely) boost returns. Always be sure you have adequate term life insurance in place prior to cancelling any life insurance policy.