I recently stumbled on your podcasts looking to educate myself a bit about my finances. I’ve listened to over 100 in less than a month and I plan on listening through all. Very helpful and much appreciated. Thank you!!
I heard your podcast about whole life insurance and how that is a poor investment (or not an investment at all!). I have a financial adviser who has been decent, and when I asked about whole life insurance 2 years ago, he advised me against it. He did tell me that he himself has whole life insurance that he is using as an investment. I insisted, since some of my close friends who I think are money savvy all have whole life, and my adviser does as well. Both my husband and I enrolled in whole life in 2017. I pay $500/mo for 500,000 benefit, my husband pays ~400 /mo for 250,000. I am 45, he is 46. He has some health issues.
I am debating whether to get rid of the insurance and just get what’s left of the cash value before we bleed out any more money. I recall reading or hearing about switching whole life insurance to a variable annuity, and when the value comes up to the total that I put in for the whole life ins, take out the money - tax-free. I cannot recall where I found that suggestion. I understood it that I would not be taxed on the growth since I would be taking out the total that I originally paid for the whole life insurance. I understand the very basics when it comes to investing, but I am completely at a loss when it comes to annuities. I am continuing to educate myself but while I do it’s painful to watch that $900 coming out of our checking account post-tax every month, knowing that most of it I won’t be getting back (ie. that neither my husband nor I will die any time soon). I’ve searched for more information but I didn’t find anything specifically related to converting whole life to annuity. Could you please direct me to any information you posted regarding this situation? I know I will feel dumb telling my adviser that I should have listened to him and to cancel it, but I want to have a better understanding of what I am doing so I don’t end up with another money wasting product.
Margaret Bialas, MD
We get questions like this all the time, and converting whole life insurance to an annuity may seem straightforward, but it isn’t. Let’s first explore when you should convert one.
When You Should Convert Whole Life Insurance to an Annuity
Had you purchased a whole life insurance policy several years ago, its probably accumulated a lot of cash. Or maybe you’re entering retirement and facing high medical costs, mortgage payments, or a weak investment portfolio.
In these types of cases, the cash from your insurance policy can provide multiple benefits. And it's better to use it now than later. This is particularly true if your dependents don't have strong needs for death benefits.
A whole life insurance policy will not only offer significant death benefits, but it will also accumulate a cash value. A part of the premium is invested, which helps build the cash value.
You can also access the cash value as your funds grow tax-deferred. A whole life policy will accumulate cash value slowly during the first few years, but it can pick up a considerable pace after several years.
Eventually, your policy might earn enough to pay the premium of the policy. This can even pay your premium until your death.
You can obtain the cash from your policy in several ways:
- You can sell the policy to a life settlement company
- Exchange your policy for an annuity
- Cash in the policy and allow it to lapse or make partial withdrawals
Therefore, a whole life insurance policy is versatile, and it will enable you to gain benefits in several ways.
One way to get benefits from your whole life insurance policy is to convert it into an annuity. You can use the Section 1035 Exchange to make it happen.
You need not pay taxes on your gains with this financial procedure. The Section 1035 Exchange is a provision in the tax rules, which allows policyholders to make tax-free transfers from their whole life insurance policy to a different policy.
You can also use this provision to obtain tax benefits for exchanging other policies, besides whole insurance. For instance, you can use this provision to convert an annuity or an endowment into a different policy tax-free.
Benefits of Converting Whole Life Insurance to an Annuity
Once you’ve converted your whole life insurance into an annuity, you won’t have to pay a premium. But you’ll also have to forego the death benefits.
In its exchange, you'll receive a fixed income for the rest of your life.
Although there is no tax on the conversion, you must pay tax for each payout. This depends on the size of your gains as compared to the basis.
Remember an important factor:
The 1035 exchange is an irreversible transaction. You cannot convert your annuity back into whole life insurance if you change your mind later on. So think about it carefully before making such a conversion.
What Will Happen if You Don’t Use 1035 Exchange to Convert Whole Life Insurance to an Annuity?
The most significant benefit of the 1035 exchange is that it allows you to make the transaction tax-free. This is much better than cashing out your policy.
Here is what will happen if you don't use the 1035 exchange for the conversion:
- You will first have to cancel the policy
- You must then transfer the amount to a bank account and use it to purchase your annuity
- You will also be taxed on gains you have earned on your whole life insurance (these taxes can be substantial)
Although the conversion itself is tax-free, you must pay taxes at a later stage. You must pay taxes on the payouts from your annuity.
Here Is How You Can Convert Your Whole Life Insurance Policy into an Annuity
Whole life insurance policies also provide cash value, besides other life insurance benefits. Cash value is the amount that the insurance company invests so it can grow.
If you don't need life insurance anymore, it may be better for you to transfer the cash value to an annuity.
The prime advantage of an annuity is that it offers a higher rate of return than a whole life insurance policy. They also provide better payout benefits in guaranteed income for the rest of your life.
Call your insurance carrier and inquire about the cash in your policy. Without cash value, you cannot convert your policy into an annuity.
Know how much premium you have paid towards your life insurance policy. When you get payments from the annuity, the funds from premiums will be tax-free.
Search for an annuity provider that will make the most substantial payments. Each annuity has its own fees, investment strategy, and payout rate.
Companies offer different amounts of payments for annuities. These factors can make a significant financial difference eventually.
So, be very careful about making a commitment since you’ll earn a fixed amount, which won’t change for the rest of your life. it’s advisable to take the assistance of a financial planner to get the highest payout.
Insurance companies often offer annuities. Hence, ask your insurance carrier about the same. Compare its payouts to other products in the annuity market.
If you settle for an annuity company, inform them you wish to provide cash from your previous life insurance policy. The company representative will help you to fill out the forms via a 1035 exchange.
A Few Reasons to Consider Converting Your Whole Life Insurance Policy into an Annuity
Here are further reasons you might want to convert your whole life insurance to an annuity:
- Changes to health can have substantial implications. If your health condition has changed substantially since your application, then you may have to pay higher premiums. You may even be denied coverage.
- Study any changes to provisions within the policy. Follow any changes to requirements carefully since it's possible that claims that were allowed under the older prerequisites may be denied under the new provisions. You can lose your benefits if you're not careful about changes to the regulations.
- The new coverage may have a higher premium amount due to issuance at an older age.
Only convert life insurance to an annuity if you’re sure that you don’t need coverage from the policy. Before making the conversion, you need to understand life insurance policies and annuities thoroughly.
Whole life insurance and annuities have a few similarities, but they also have significant differences. Therefore, understand their vital elements before selecting one for yourself.
If you die earlier than expected, a life insurance policy will offer a lump sum payment to your dependents. Life insurance policies have two broad categories: term-life and whole life insurance.
A term-life insurance policy provides coverage for a specified period. This could be 10 years, 20 years, or even more.
A whole life insurance policy lasts throughout the policyholder’s life. Some term-life insurance policies have a provision that allows policyholders to convert them to whole life insurance after the expiration of the terms.
A life insurance policy provides additional benefits besides just death benefits. It can provide cash value and other options for earning income, while some even offer an opportunity for critical care coverage.
However, this is not the main purpose of a life insurance policy. The primary benefits are that it will pay lump sum benefits to your dependents upon your demise and also cover your funeral expenses.
An annuity plan aims to provide guaranteed income to individuals living beyond their life expectancy. Annuities generate retirement income through tax-deferred savings.
An annuity can provide death benefits to beneficiaries. However, this death benefit will be taxed. Here are the main types of annuities:
As the name suggests, income payments are deferred to a later date, possibly up to several years. Deferred annuities are further subdivided into variable, fixed index, and traditional annuities.
There are a few key differences between these annuity plans. For instance, interest earned and the risk level are different.
Depending on the preference of the investor, the annuity plan may offer greater returns for higher market risks. It may also provide relatively lower yields as a safe investment.
An immediate annuity will pay benefits within a year of your premium payment. You can purchase this annuity through a single lump-sum payment. It will offer guaranteed income for the rest of your life.
This plan provides protection against the risk of outliving your savings. Longevity annuities can help those who have exceeded their life expectancy.
You will receive payouts from the longevity annuity plan after you cross 80 years of age or more. After payouts begin, you'll receive fixed payments, no matter how long you live.
As usual, the longer you defer payments, the higher your payouts will be. This is because money will grow in your account if you abstain from making payments. A longevity annuity is similar to a deferred annuity.
Since it offers protection against the financial impact of longevity, a longevity annuity policy is a supplemental investment for your retirement plan. However, if you die before payments start, your heirs will receive nothing.
Annuities are a reliable way of ensuring a steady income stream during your retirement years. They are particularly helpful for people approaching the retirement age who need to catch up on their savings.
Advantages of Annuities
Here are the benefits of annuities:
- With annuities, you don’t have to face annual contribution limits. After you have made the maximum possible yearly contributions to your IRA and 401(k), you can contribute as much as you like to an annuity. Annuities are a great way of catching up on your savings if you have fallen short just before retirement. This is because there is no restriction on how much you can contribute towards annuities.
- Annuities carry risks far less than mutual funds.
- With fixed annuities, the company bears investment risks. You're guaranteed to receive a fixed interest rate, despite market performance. However, with a variable annuity, you can possibly earn returns higher than a fixed annuity.
- A variable annuity offers flexibility. You can select your own investments in the stock market.
- For deferred annuities, you'll not be taxed on investment gains.
- Annuity payments last as long as you live. You don’t have to worry about outliving your savings. Suppose you’re in your late 60s. If you purchase an immediate annuity with $110,000, then you’ll receive about $7,000 each year. If you live for another 20 years, you’ll earn $140,000. This is an excellent return, which is higher than your purchase price.
- With a variable deferred annuity, death benefits will be paid to your beneficiaries.
Disadvantages of Annuities
There are also certain disadvantages you must know about before you invest in an annuity.
- You must pay taxes on your annuity income in the same way as regular income. The tax rate might increase by the time you draw payments from your annuity.
- The company providing the annuity can keep the remaining amount after your death. Here is an example. Suppose you purchase an immediate annuity with $110,000, you'll get around $7,000 every year in returns. If you die after just 10 years of the purchase, you would have earned only $70,000. The company will keep the remaining amount. You cannot pass annuities to your relatives. For this, you must buy an additional rider. But this will come at an extra cost.
- The consistency with which payments are made depends on the financial strength of the company you purchased the annuity. If the company goes bankrupt, then you won't get payments.
- There may be several fees associated with your annuity, such as trading fees, advisor fees, and account management fees. You must pay a surrender charge of about 10% if you withdraw money within a specified period.
- You cannot make investment choices with fixed annuities. You can make investment choices with a variable annuity, but you must face market risk.
- You cannot buy an annuity if you're young. You can purchase a deferred annuity if you're 40 years old and an immediate annuity if you're 55.
One apparent reason to convert your whole life insurance policy to an annuity is that you no longer need the coverage. This can happen if you have paid off all your debts and your children have become independent.
Making the right decision involves analyzing your purpose. If you want to leave behind a generous amount for your beneficiaries after your demise, go for whole life insurance.
But if your purpose is to obtain a safe retirement income source, then an annuity is a great choice.
Your goals and needs may change as you get older. Early on, you'll be more focused on safeguarding the financial well-being of your dependents.
Later on in life, (after your children have become independent and your debts have been paid off), you’ll probably be more focused on a secure retirement.