Should life insurance be renewed in retirement?

Dear Liz: My life insurance policy of $500,000 will end in four years, when I’m 63. My wife’s policy ends at age 62. Our kids are 28 and 25 and successfully launched with careers. I also have a $180,000 life insurance policy through my job that expires when I plan to retire, also at age 63. My wife and I have long-term-care insurance policies. We have $170,000 in an active investment account plus $1.4 million in our 401(k)s. Our kids also have trust funds that they will get when they turn 30 of about $80,000 each. Should I buy more life insurance for 10 to 15 years? Our estate, which is in a living trust, will pass to the kids. Our house is worth about $1 million.

Answer: The first question you must ask when it comes to life insurance is whether you need it. If you have people who are financially dependent on you, you typically do. If your wife has sufficient retirement income should you die, and vice versa, then you probably don’t.

So-called permanent or cash-value life insurance is often sold as a way to pay estate taxes, but again, it doesn’t look as if you’ll need that coverage. Congress increased the estate tax exemption limit for 2012 to $5.12 million, and that amount is tied to inflation going forward.

Still, this is a good question to pose to a fee-only financial planner, and you should be seeing one for a consultation before you retire in any case. Retirement involves too many complicated, irreversible decisions to proceed without help.

Advice not to fund 401(k) is a red flag

Dear Liz: You recently suggested an insurance salesman be reported to state regulators because he suggested a reader stop funding a 401(k) and instead fund an insurance contract with after-tax dollars. You were way out of line. It’s very likely tax rates will be going up, so it may make sense to trade a tax benefit now for a better one in the future.

Answer: You might have a valid point if the reader were wealthy enough to be funding a life insurance policy or annuity in addition to his 401(k) contributions. Wealthier people are already facing higher tax rates, and they are more likely to be in the same bracket, or perhaps even a higher one, when they retire.

The fact that the insurance salesman suggested the reader redirect his retirement contributions to the insurance contract indicates the reader didn’t have the cash flow to do both. So it’s still quite likely that the reader will drop into a lower tax bracket in retirement, in which case he’s given up a valuable tax break now for a less valuable one in the future.

A red flag should go up anytime an insurance salesperson recommends you stop funding a tax-deductible retirement plan or that you tap home equity to buy whatever he or she is selling. That indicates the product was designed for someone wealthier than you. At the very least, you should run the purchase past a fee-only financial planner — someone who doesn’t earn commissions on product sales — to make sure you’re getting the whole story.

Get second opinion before buying cash-value insurance

Dear Liz: I think you missed one of the possibilities when a reader wrote to you about a pitch he received from an insurance salesman. The salesman wanted the reader to stop funding his 401(k) and instead invest in a contract that would guarantee his principal but cap his returns in any given year. You thought the salesman was pitching an equity indexed annuity, but it’s possible he was promoting an indexed universal life policy, which would offer the same guarantees of principal and offer tax-free loans.

Answer: You may be correct — in which case the product being pitched is just as unlikely to be a good fit for the 61-year-old reader as an equity indexed annuity.

Cash-value life insurance policies typically have high expenses and make sense only when there’s a permanent need for life insurance. If the reader doesn’t have people who are financially dependent on him, he may not need life insurance at all.

Furthermore, the “lapse rate” for cash-value life insurance policies tends to be high, which means many people stop paying the costly premiums long before they accumulate any cash value that can be tapped.

Before you invest in any annuity or life insurance product, get an independent second opinion. One way is to run the product past a fee-only financial planner, who should be able to analyze the product and advise you of options that may be a better fit for your situation. If you just want a detailed analysis of the policy itself, you can pay $100 to EvaluateLifeInsurance.org, which is run by former state insurance commissioner James Hunt.

Insurance better than 401(k)?

Dear Liz: Recently, someone from an insurance company proposed that I stop investing through my 401(k) at work and instead invest in his insurance company contract with after-tax dollars. He claims the funds would be guaranteed so that I would never lose principal, although there would be a cap on how much I could make in any given year. His claim is that it is better to forgo the tax deduction I would get from my 401(k) contributions so that I can take the money out of this contract tax-free in 20 or 30 years. I think I am too old for this program (I am 61 now) but I thought it might be appropriate for my daughter when she enters the workforce in a few years.

Answer: You may have been pitched an equity-indexed annuity. These are extremely complex investments that should not be purchased from someone who misrepresents how they work and who encourages you to forgo better methods of saving for retirement.

Withdrawals from annuities are not tax-free. You would not have to pay income tax on the portion of the withdrawal that represents your initial contributions, but any gain would be taxable at regular income tax rates.

Furthermore, most people fall into a lower tax bracket in retirement. That makes the tax break offered by 401(k) contributions especially valuable, because you’re getting the deduction when your tax rate is higher and paying the tax when your rate is lower.

The Financial Industry Regulatory Authority, which regulates securities firms, has warned that most investors consider equity-indexed annuities and other annuity products “only after they make the maximum contribution to their 401(k) and other before-tax retirement plans.”

Even then, you probably have better ways to save. Contributions to a Roth IRA would not be tax-deductible, but withdrawals in retirement would be tax-free. If you’re able to save still more, you could contribute to a regular, taxable brokerage account and hold your investments at least one year to qualify for long-term capital gains rates, which are lower than regular income tax rates.

The other possibility is that the insurance salesman was pitching a life insurance policy that would allow you to take out a tax-free loan. Although life insurance is sometimes pitched as a retirement savings vehicle, it’s an expensive way to go. In general, you should buy life insurance only if you need life insurance. To help ensure a policy is suitable for your situation, you should take it to a fee-only financial planner—one who does not make commissions from selling investments–for review.

In any case, you don’t want to do business with someone suggests you stop funding your workplace retirement plan, and you certainly don’t want to refer him to family members. What you should do instead is pick up the phone and report him to your state insurance department.

Term or whole life? What you need to know

Dear Liz: My mother and her insurance agent swear by whole-life insurance policies. I am 45 and have heard from everyone else to only have term life, which is what my husband and I both have. We have a 15-year-old daughter. Can you please put in layman’s terms what a whole-life policy is and what the benefits are?

Answer: Term insurance provides a death benefit if you die during the “term” of the policy. Term insurance provides coverage for a limited time, such as 10, 20 or 30 years. It has no cash value otherwise and you can’t borrow money against it.

Whole-life policies combine a death benefit with an investment component. The investment component is designed to accumulate value over time that the insured person can withdraw or borrow against. Whole-life policies are often called a type of “permanent” life insurance, since they’re designed to cover you for life rather than just a designated period.

If you need life insurance — and with a daughter who is still a minor, you certainly do — the most important thing is to make sure you buy a big enough policy to cover the financial needs of your dependents. This is where whole-life policies can be problematic, since the same amount of coverage can cost up to 10 times what a term policy would cost. Many people find they can’t afford sufficient coverage if they buy permanent insurance. Also, many people don’t have a need for lifetime insurance coverage. Once your kids are grown and the mortgage is paid off, your survivors may not need the coverage a permanent policy would provide.

If you are interested in a whole-life policy, make sure to run it by a fee-only financial planner who can objectively evaluate the coverage to make sure it’s a good fit for your circumstances.

Don’t buy life insurance if you don’t need life insurance

Dear Liz: I recently inherited around $200,000. I’m on track for retirement, so my broker is encouraging me to consider buying a policy for long-term care. He recommends a flexible-premium universal life insurance policy that requires a one-time upfront payment and provides a death benefit as well as a long-term care benefit. It does appear to me to be a better option than buying a long-term care policy in which I pay a certain amount every month, which can of course increase greatly as time goes on, with no guarantee of ever needing or using the benefits and no hope of money paid in becoming part of my estate.

Answer: Long-term care policies can indeed be problematic, since the premiums can soar just when you’re most likely to need the coverage. So if you need life insurance for another purpose — to take care of financial dependents should you die or to pay taxes on your estate — then a life insurance policy with a long-term care rider may not be a bad idea, said Laura Tarbox, a fee-only Certified Financial Planner in Newport Beach who specializes in insurance.

But buying life insurance when you don’t need it just to get another benefit, such as long-term care coverage or tax-free income, is often a costly mistake.

“The golden rule is that you do not buy life insurance if you don’t need life insurance,” Tarbox said. “It would probably be better to invest the money and have it earmarked for long-term care.”

If you decide you want to buy this insurance, don’t grab the first policy you’re offered. Shop around, because premiums and benefits vary enormously. The financial strength of the insurer matters as well. You want the company to still be there, perhaps decades in the future, if you should need the coverage.

What you don’t want to do is take guidance solely from someone who is going to make a fat commission should you buy what he or she recommends.

“Get two or three proposals from different agents,” Tarbox said. “A fee-only financial planner can help you sort through them.”