Ask Liz Weston

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Insurance

Q&A: Should I borrow against my life insurance to travel?

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Dear Liz: My wife and I live on her pension, my Social Security, and enough dividends from our blue-chip stocks to cover our daily living expenses. But at our age (80), we would like to spend a little more in order to travel. We will have to borrow the money for that. I see that I can take a loan against our life insurance, at a very low rate of around 2%. The alternative is to take a margin loan, which currently costs 8.75%. It appears to me I should be borrowing against life insurance (we’re thinking of a loan of $10,000, against the life insurance face value of $900,000), where repayment would be assured from proceeds at the time of death (if not sooner, depending on our regular cash flow). Are there pitfalls to using life insurance loans?

Answer: There are pitfalls to any kind of loan, so you’re smart to want to educate yourself before you borrow.

Life insurance loans allow you to borrow against the cash value that’s accumulated in a permanent life insurance policy, such as a whole or universal life policy. The cash value is the savings component of your policy that’s typically built up over time. It’s not the same as the face value, which is how much the beneficiary is supposed to be paid when you die.

You typically have a lot of flexibility over how you pay the money back. If the policy allows, you can even opt to make no payments and have the loan plus interest deducted from the death benefit.

The big risk, besides leaving a beneficiary short of funds, is that the debt could grow to the point where it exceeds the policy’s cash value. At that point, the policy can lapse and potentially trigger taxes on the borrowed money.

You may have other options to fund your travel, such as selling some stocks, borrowing against your home equity or even taking out a reverse mortgage. Each option has advantages and pitfalls, so you’d be wise to discuss your situation with a fee-only financial planner for personalized advice.

Q&A: Losing a home in a fire, then being hit with a ‘casualty gain’

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Dear Liz: My house was burned down in the Palisades fire. I lived in the house for 25 years and lost everything. I thought there may be a silver lining with tax deductions. Much to my surprise, I am supposed to use the purchase price from 25 years ago as my adjusted cost basis. The insurance settlement is not going to be enough to rebuild but is more than my cost basis. I will end up with “casualty gain” instead. Is this possible?

Answer: After losing your home and finding out you were underinsured, the news that you might have a taxable gain must have been a gut punch.

The IRS calls it an “involuntary conversion” when your property is destroyed and you receive insurance proceeds. If the insurance payment exceeds your tax basis in the property, that’s known as a casualty gain.

You can defer tax on this gain if you use the insurance payout to rebuild or buy a replacement property, says Mark Luscombe, a principal analyst with Wolters Kluwer Tax & Accounting. Normally you’d have two years to use the insurance proceeds, but in a federally declared disaster such as the Los Angeles fires, the deadline is extended to four years.

The IRS may be willing to further extend the deadline under some circumstances, such as contractor delays, Luscombe says. But don’t count on an extension if you’re simply unable to find a replacement property.

If you do purchase a new home elsewhere, any gain from the sale of the lot where your previous home stood also would have to be reinvested in the new home to avoid a current tax on the gain, Luscombe says.

However, the home sale tax exclusion also applies to involuntary conversions. The exclusion allows you to shelter up to $250,000 of gains ($500,000 if married filing jointly) on a sale or involuntary conversion, as long as you’ve owned and lived in the property as your primary residence for two of the last five years. So you could exclude that amount of gain and defer the rest if you rebuild or find a replacement property, Luscombe says.

This is complicated territory, so please make sure you hire a tax pro to guide you.

Q&A: Does insurance cover a home in a living trust?

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Dear Liz: All of our insurance policies list my name and that of my husband. After the recent devastating Los Angeles fires, I heard from friends that we should add the name of our living trust to our home insurance policy because our house is in the trust. Otherwise, they say, some insurance companies may not cover loss or damages to it due to the discrepancy in the names, even if the trust has both of our names as trustees. Would you please confirm this?

Answer: Yes. If your home is in a trust, your insurance policies should list your trust as an “additional insured.” Insurance companies vary in their contract language, but you don’t want to find out after the fact that you aren’t covered.

Q&A: How to Choose a Trusted Financial Advisor for Long-Term Care Insurance and Asset Protection

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Dear Liz: My 68-year-old husband has Alzheimer’s disease. I thought we were responsible, having a nice nest egg of over $2 million, a house that is paid off and no debts. However, I am now terrified that it will all be depleted because of long-term care costs. Per your advice, I consulted a fee-only financial planner to get his opinion about long-term-care insurance for myself (my husband no longer qualifies). Turns out he will be the one to get the policy for me, should I decide to go forward. I feel uncomfortable that the financial advisor has an obvious stake with this long-term-care policy and therefore might be biased with his advice.

Answer: Understandably. If the advisor would earn a commission from this policy, as your question implies, then he is not a fee-only financial planner. Fee-only planners receive payment only from their clients, not from commissions or other arrangements that could bias their advice.

Long-term-care insurance is expensive, and you’d be smart to take any policy you were considering buying to a fee-only planner committed to putting your best interests first. Most advisors don’t have to uphold this type of fiduciary standard.

You can get referrals to fee-only planners from the Garrett Planning Network, which represents advisors who charge by the hour; the XY Planning Network and the Alliance of Comprehensive Planners, which represents those who charge retainers; and the National Assn. of Personal Financial Advisors, which includes planners who charge a percentage of the assets they manage.

Also consider talking to an elder law attorney, who can advise you about possible ways to protect your assets from depletion. You can get referrals from the National Academy of Elder Law Attorneys.

Q&A: My house grew, but not my insurance policy

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Dear Liz: My home insurer has outdated specifications for my home that seem to come from public records (the house has more bedrooms and is larger now). So the estimated replacement cost can’t be anywhere near accurate. What’s the best way to provide them with authoritative information that would leave no doubt what we need to rebuild if that becomes necessary? An appraisal?

Answer: An appraisal may be overkill, but you’re long overdue for a conversation with your insurance agent.

Ask the agent to calculate the cost to rebuild your home given the actual square footage and other features. Insurers use proprietary systems to calculate these costs, so you may also want to check with two or three other companies. Also consider talking to a local contractor or two to find out the average cost to rebuild in your area.

Going forward, you should be checking to make sure your coverage is adequate every two or three years and after any major improvements.

Your premiums are likely to rise, perhaps substantially, once your insurer has the correct information. But your policy will do what it was designed to do, which is to protect you from a catastrophic loss. Otherwise, you could be left without enough money to rebuild.

Q&A: These major financial decisions shouldn’t be DIY projects. Talk to an expert!

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Dear Liz: I anticipate being dead soon (cancer). I have established an irrevocable trust for my 8-year-old child, with my 47-year-old wife as the trustee. With respect to taxes and other issues and naming beneficiaries, what is the optimal strategy regarding my child for life insurance and traditional and Roth IRAs? My wife will get the 401(k).

Answer: The best person to answer those questions is the estate planning attorney you (presumably) used to create the irrevocable trust. Estate planning should not be a do-it-yourself activity, particularly when minor children are involved. The wrong plan could give too much too soon to your child, or tie up the money too long. You also don’t want to unreasonably stint your wife in your efforts to preserve money for your child. Also, the optimal strategies for tax purposes may not be the best for your family’s situation.

For example, the best way to minimize taxes may be to leave all the retirement money to your wife. Spouses who inherit retirement funds have the option of treating the accounts as their own. That means your wife wouldn’t have to begin required minimum distributions from the 401(k) or the traditional IRA until she’s 75. (The current RMD age is 73, but it rises to 75 for people born in 1960 and later.) She would not have to take distributions from a Roth IRA she inherits from you.

Non-spouse heirs generally have to drain retirement accounts within 10 years. Minors who inherit retirement funds don’t have to take the first distribution until they turn 21, but then the accounts must be emptied within 10 years.

Life insurance proceeds typically aren’t taxable, or payable to a minor child. But you can create a trust to receive and dole out the proceeds to your child. Your estate planning attorney can help you set this up.