Life Insurance - surrender the whole thing or just dividends earned?

[Muse]

My dad took out a $10,000 life insurance policy for me (I'm the insured) when I was 12 years old and continued to pay the premiums until it was fully paid up. He and my mom were the beneficiaries at the time. He has since died, my mom is alive. Around 10 years ago he handed me the policy, telling me that I could surrender it for cash but I might not want to because of prohibitive tax exposure (in a letter I still have). Now I need cash and am thinking about surrendering the policy or possibly just the dividends earned, leaving the policy still in effect. I have no dependents and I'm unmarried, so it doesn't make sense to me to have life insurance at the present time. But unless I'm misunderstanding things it looks to me like I will get more money if I surrender the dividends earned now and the policy in total later (maybe a year or two?) than if I surrender the entire thing at one time.

I never got statements and wondered what the hell was going on, but never did anything about it until a month or two ago. I finally called them (MassMutual), and found out a few things, had some info sent to me. Evidently the yearly statements were going to my dad's old address, so I asked them to change the address for the "premium payer" to me, so info would go to me. I have a statement now and a "tax quote request" letter.

I'm confused about this because it appears to me that I would have much more tax exposure if I surrender the entire policy than if I just ask them to cut me a check for the dividends earned. If I do the latter I get (as of right now) $13,684.41 and it's not taxable. If I surrender the entire policy right now I'd get $21,669.31 but about $17,500 would be taxable. That seems just plain weird, and in talking to MassMutual CSRs on the phone, the two I asked about this today just said that they aren't tax experts and they can't explain why I'd have so much more tax exposure by surrendering the entire policy. I'm not in desperate need of cash, that's not an issue. I just want to get the cash out of the policy without more tax exposure than I need to have. My current income is from interest and dividends, inasmuch as I'm unemployed. Been unemployed for around 3 or 4 years. In 2008 I came in under the wire and with the standard deduction I didn't owe any federal taxes at all (I do my own taxes with Turbo Tax and before 2008 I never did better taking the standard deduction, but TT said I would this time). I figure it will be the same this year unless I surrender this entire policy. $17,500 taxable income would surely have me paying federal income taxes. Obviously, if I just have the earned dividends surrendered, I'd again pay no income tax. One reason I want to deal with this now is that I think I might have increased tax exposure in the future either because of job income, self employment if I can figure something out or income from investments (if my mom dies I will get an inheritance).

If I get just the dividends earned now and have the policy surrendered in total at a later time (say in a year or two), it appears to me that my total tax exposure from surrendering this policy has to be less than surrendering the whole thing now, and by a lot ($17,500 vs. maybe a few thousand dollars). Why the disparity? Am I missing something here? The MassMutual people can't explain it.

I don't want to take a loan against the policy because the loan interest rate is 5% and I can get a better rate with my HELOC (3.75%).

Here are the figures:

From the annual statement I just received:

Basic Policy: $10,000
Fully Paid Additional Insurance: $17,858
Settlement Dividend: $322
Total Insurance Coverage: $28,180

Cash Value Summary

Basic Policy $7,631.90
Fully Paid Additional Insurance: $13,629.25
Settlement Dividend: $322
Total Cash Value $21,583.15

Dividend Option: Paid Up Additional Insurance



The Tax Quote Request letter they sent me 3 weeks ago says:


Basic Cash Value: $7,655.20
Dividends Earned: $16,510.54
Total Amount Earned: $24,165.74

Premiums Paid: $7,023.56
Taxable Gain: $17,142.18

The letter goes on to say:

"Taxable gain is calculated by comparing the amount you paid into the policy (premiums paid) to the amount received during the life of the policy (cash value and dividends).

If your dividend option is Dividend Accumulation, the amount of interest is not included in the calculations."

What is the smart course of action here? Is it really tremendously advantageous to me to have them write me a check for the dividends earned now and surrender the rest of the policy in a year or two rather than surrender the entire thing now? Or is this a mirage and I'm not understanding the situation? I want to make a decision before the new year so that what I do now will count in the 2009 tax year.

 

[Bignate603]

1. Find a good accountant
2. Pay him for 30 minutes of his time and bring all of your paperwork
3. Ask your question
4. Profit

 

[TubeTote]

1. Find a good accountant
2. Pay him for 30 minutes of his time and bring all of your paperwork
3. Ask your question
4. Profit

I could not agree more. I do insurance, but this is more of a tax and estate planning question. Just for the record, I usually advise folks to keep their life insurance policies intact for a number of reasons. Not having an immediate family doesn't necessarily mean that there are no benefits. One very important thing to remember...the older you get, the more difficult and expensive it is to obtain life insurance. If you develope any kind of serious illness, you may not even qualify.

Peace~

 

[PowerEngineer]

1. Find a good accountant
2. Pay him for 30 minutes of his time and bring all of your paperwork
3. Ask your question
4. Profit

Clearly the right answer...

That said, we had similar policies set up for our kids (by their grandparents) at the time of their birth as college savings plan. This was prior to the tax law changes that allowed 529 accounts, etc. The whole life insurance policy was a means of deferring taxes on the earnings that the money earned over eighteen years.

When it was time to go to college, they had three options:

1) Not use the whole life insurance policy at all (by finding some other way to cover college costs), in which case the value continues to grow (tax-deferred) and becomes something akin to an IRA (without early withdrawal penalties).

2) Take cash distributions, in which case the value drops (and then grows much more slowly). The first money taken out has to be the initial investment (i.e. the premiums paid), and since this money had already been taxed, it is not income that is taxed. After the initial investment is withdrawn, subsequent withdrawals (being the tax-deferred earnings) become taxable income. If you withdraw too much, then the earnings on what value remains may be too small to cover the continuing premiums and the value of the policy will begin to decrease.

3) Borrow money against the policy, in which case you get the cash when you need it but then have to pay it back over time. My understanding is that this avoids the tax consequences of taking distributions of earnings.

The way I look at these policies, they're a lot like an IRA or a 401k. Even without the penalties for early withdrawal, I'd be really reluctant to pull money from any tax-deferred investment.

My two cents...

 

[bruceb]

Yes, get an accountant. But basically the reason for the tax issue is simple.

Basic Cash Value: $7,655.20 is what the policy value started at.The redemption paid upon death. It would be taxed as Ordinary Income or a Long Term Gain, if you cash it in.

Dividends Earned: $16,510.54 ... you earned this, but it is still not taken out. It is taxed when removed or paid to you. This should be a Long Term Gain as well.

Total Amount Earned: $24,165.74

Premiums Paid: $7,023.56 ... this was yours so, non taxed

Taxable Gain: $17,142.18

 

[Muse]

Yes, get an accountant. But basically the reason for the tax issue is simple.

Basic Cash Value: $7,655.20 is what the policy value started at.The redemption paid upon death. It would be taxed as Ordinary Income or a Long Term Gain, if you cash it in.

Dividends Earned: $16,510.54 ... you earned this, but it is still not taken out. It is taxed when removed or paid to you. This should be a Long Term Gain as well.

Total Amount Earned: $24,165.74

Premiums Paid: $7,023.56 ... this was yours so, non taxed

Taxable Gain: $17,142.18

So how come I can get "dividends earned" now of $13,684.41and it's not taxable? More than one of their CSR's told me that. Are they wrong?

I hadn't thought of the IRA-like qualities of this policy and it has me wondering if I shouldn't hang on to it. I've been getting squeezed for cash. I have equity but am trying to figure out the least hurtful way of getting at it. Thanks for the replies.

 

[Muse]

Yes, get an accountant. But basically the reason for the tax issue is simple.

Basic Cash Value: $7,655.20 is what the policy value started at.The redemption paid upon death. It would be taxed as Ordinary Income or a Long Term Gain, if you cash it in.

Dividends Earned: $16,510.54 ... you earned this, but it is still not taken out. It is taxed when removed or paid to you. This should be a Long Term Gain as well.

Total Amount Earned: $24,165.74

Premiums Paid: $7,023.56 ... this was yours so, non taxed

Taxable Gain: $17,142.18

They tell me that my dividend option is reinvest, so what goes up is the death benefit, which doesn't interest me. I can get my dividends earned, almost $14,000, and the death benefit will shrink from $28,000 or so back to $10,000. The dividends earned (almost $14,000) will NOT be taxable. This is what they say. Are they wrong?

 

[richardycc]

can't you just take a loan against the life insurance?

 

[Muse]

can't you just take a loan against the life insurance?

Yes, I could do that but I believe that the APR would be worse than my HELOC, which is currently 3.75%. I'm already a little dipped into that and would like to avoid more.

 

[JEDIYoda]

Are you a complete moroan or something???

You have been advised by several people to get an accountant!!

You really do not want to make your decision by discussing this with the kiddies of these forums!!

 

[Muse]

Are you a complete moroan or something???

You have been advised by several people to get an accountant!!

You really do not want to make your decision by discussing this with the kiddies of these forums!!

Why not? Paying a pro however many $20 bills for 1/2 hour of advice is no guarantee of being pointed in the right direction. Frankly I'm not sure there are any right answers here, anyway. I'm just trying to get a handle on the issues. If I understand what the hell is going on, why would I need to pay some person a bunch of money to make up my own mind? Who's the moron? I have never hired an accountant, even for my taxes.

 

[Elbryn]

my understanding is that these things work in that you taxed dollars into the policy. value grows tax deferred. therefore when you take money out, anything you take out up to the amount you have paid in total is not taxable. anything beyond that is into the money that grew tax deferred and therefore is taxable.

cutting you a check for dividends earned doesnt matter. all that matters is how much you're getting compared to the amount that was paid into the policy. if you paid 5k into the policy and are requesting 5k of money out, it's the same as pulling back the 5k you paid in, therefore tax neutral. if you want to pull 9k out, 5k is not taxable and 4k is taxable.

it looks like there are some internal policies in play that penalize you for withdrawing. different options have different penalties. read your policies manual and find out what rules they are playing by.

i'd suggest cashing out of the whole life insurance racket. it's far cheaper for more coverage to go term. you can get a million dollar policy for 20 years at a cost of 500ish a month. if you're considering this a retirement vehicle, you'd be better served pushing it into a roth ira and with your low income, getting a match from the government.

 

[Fizzorin]

I'm confused about this because it appears to me that I would have much more tax exposure if I surrender the entire policy than if I just ask them to cut me a check for the dividends earned. If I do the latter I get (as of right now) $13,684.41 and it's not taxable. If I surrender the entire policy right now I'd get $21,669.31 but about $17,500 would be taxable. That seems just plain weird, and in talking to MassMutual CSRs on the phone, the two I asked about this today just said that they aren't tax experts and they can't explain why I'd have so much more tax exposure by surrendering the entire policy.

There are two effects in play here.

1- Whole life insurance dividends. Technically, they are NOT dividends. When a policyowner purchases a policy from a participating insurer, he or she actually pays a "grossed up" premium. The higher premium is charges as a safety margin in the event the insurer's experience is higher than anticipated. If this overcharge is not needed by the insurer to pay death claims and expenses, or if the actual mortality experience improves or interest earned by the company exceeds the assumptions, a dividend will be paid to the policyowner. In other words, dividends are a return of excess premiums, and for that reason they are not taxable to the policyowner. Insurance companies cannot guarantee dividends.

2- The policyowner is not taxed on the annual increase in cash value as this accumulates on a tax-deferred basis. If the policyowner withdraws any of the cash value or surrenders the policy for the cash value, the amount of cash value that exceeds the sum of the total premiums paid will be taxed to the policyowner as ordinary income. This is called the Cost Recovery Rule and ensures that whole life insurance remains insurance and not another tax-deferred investment strategy.

Oh, and you don't have to be a "tax expert" to know this, any licensed life insurance agent should be able to tell you this.

 

[TubeTote]

it's far cheaper for more coverage to go term.

Yes, you are correct that term life is very cheap...and there is a reason for that. The average cash out on term policies is about 2%. Think about it...who dies over the course of a 10 year term policy? Not very many people statistically. Plus, you still must qualify, and your rates depend on your age and health status. With most term policies, whatever you are paying is money you will never see again (if you die, somebody else will see it I guess). Everyone is entitled to their own opinion, but I consider term life a waste of money, and I only sell it to clients who have a particular need for this kind of arrangement.

If you must purchase term, there are products that actually pay you your entire premium back at the end, and many other variations on this. I don't sell a lot of life insurance, but in my opinion, if you are going to have it, whole life is the only product that makes sense for most people.

Just my two cents.