New Uses

For young families, life insurance usually is used to assure that basic needs -- such as paying a mortgage and providing for children -- will be met should the family's wage earner die. But later in life, when these original needs have passed -- the mortgage is paid off, or nearly so, and children have grown up -- your old insurance may become useful in new ways...

New obligations. Perhaps you have new mortgages (on a second home or investment property), your standard of living has increased to a level that requires extra protection or you have remarried and have obligations to a second family.

Bequests. If you wish to leave funds to children or grandchildren, you may be reluctant to spend your savings on yourself -- and your own quality of life may suffer as a result.

Strategy: Fund bequests with life insurance. This frees you to use your own assets as you wish while still providing for the younger generation.

A "second-to-die" policy that pays on the death of the survivor of a married couple can meet this purpose at low annual premium cost.

Charitable donations. Insurance proceeds similarly can provide a bequest to charity without tying up any of your assets.

Estate tax liability. Although there's much talk of the federal estate tax being repealed, this remains uncertain -- and even if it is repealed, many states will maintain their own estate taxes.

Life insurance may be needed to protect valuable family assets (home, business, investments) from the tax authorities. State estate tax rules and exempt amounts vary, so check with a local expert.

Business. If you are a key manager in your own family-owned business, insurance may be needed to protect the business from critical losses -- such as if you had key knowledge or skills that generated certain income -- in the event of your death. If you are an owner of a private business, insurance may be used to pay your survivors the value of your shares that are redeemed when you die. Typically, shares in a privately owned company are subject to a buy-back agreement so that ownership doesn't wind up with a stranger.

LETTING IT GO

On the other hand, your situation may have changed so much that your old insurance policy is no longer useful. You simply may not need insurance any more. In this case, if you've used term insurance to date, you can just cancel the policy.

If you've used a policy that's built up cash value, you will want to make the most of this value. Options...

Surrender the policy to the insurance company for its cash value.

Snag: The amount by which the cash value of the policy exceeds the premiums paid is taxable income -- which is taxed at top ordinary income tax rates, not as tax-favored capital gains.

Donate the policy to charity. If you intend to give cash or property to charity anyway, donating an unneeded insurance policy is likely a better idea. Reasons...

If the charity keeps the policy until your death, you'll have provided them a bigger legacy than by donating cash or other property.

You will avoid ever paying tax on your gain on the policy. In contrast, if you were to donate enough cash to the charity to get a deduction of the same size, you would face tax at ordinary rates when you cash in the insurance policy.

Opportunity: Donating a life insurance policy to charity is even better tax-wise than donating appreciated property (such as stock shares). In each case, taxable gain on the donated property is averted. But the gain on a life insurance policy is ordinary income, while that on stock or fund shares is tax-favored capital gain. So more tax is saved from a donation of insurance for gains of the same size.

Convert the policy to an annuity. This provides an income stream over a set period of years or your lifetime. There is no immediate tax due, and the annuity continues to earn tax-deferred investment returns. Payments from the annuity will be partly taxable as ordinary income and partly a nontaxable return of investment.

Annuity options and rules are complex, so consult an expert.

new Coverage

If you find you need more or different coverage than in the past, you will need to look for a new insurance policy.

The good news is that the insurance market has become much more competitive in recent years, so you'll probably find lower premium costs and more options available (such as investment options for cash-value policies) than when you bought your old policy.

Opportunity: When you replace an old cash-value life insurance policy with a new one, you may not have to cash in the old policy and thus incur taxable gain. You can instead replace the old policy with the new one through a tax-free exchange that defers any taxable gain until the new, replacement policy is disposed of.

Requirements: The new policy must have the same owner and the same insured (or insureds) as the policy it replaces. (The new policy can be obtained from a different insurer than the old one.)

The details of the new policy will, of course, depend on its purpose and the need it meets.

Important: Insurance rules and related tax rules are complex. Have your insurance broker explain your options and give you a detailed financial analysis that compares your old and proposed new policy. The broker is required by law to do this, but in practice, the analysis may be neglected.

Bottom Line/Retirement interviewed Elizabeth S. Sevilla, CLU, ChFC, personal financial planner specializing in life insurance and tax senior manager, BDO Seidman, LLP, One Market-Spear Tower, San Francisco 94105.