Keeping an old permanent policy affordable on a retirement income

The premium notice has not changed in thirty years, but the income it comes out of has. A paycheck became a pension and Social Security, and a bill that once felt small now takes a visible bite. The easy reaction is to stop paying. The better reaction is to spend an afternoon finding out what the policy can do for you before you give up on it, because an old permanent policy often has levers that a new one would not.

This playbook goes in order, from the steps that cost nothing to the ones that change the policy permanently. The examples are hypothetical and the numbers are round illustrations. Policies differ by contract and insurer, so the steps tell you what to ask; the answers have to come from your own policy documents and your insurer. For tax questions, a tax professional is the right person to consult.

Start by deciding what the policy is for

Every step below affects the death benefit, the cash value or both, so decide first what you want the policy to do. Common purposes in retirement:

• paying final expenses so the family does not have to;
• replacing income a spouse would lose, such as a single-life pension that stops;
• leaving something to children or a charity;
• covering a debt or an estate tax bill;
• nothing in particular, because the need has passed.

If you cannot name a purpose, the policy may be a candidate for surrender or sale, and the life insurance in retirement: keep, cut or cash out guide and the keep, surrender or sell your policy? help with that choice. If you can name one, the question is how to keep the policy doing that job at a lower cost to you. The rest of this post assumes you want to keep some coverage.

Step 1: Audit the premium

Begin with what you are actually paying and why.

1. Find the premium on the latest statement. Write down the annual amount and how often you pay. Paying monthly usually costs more per year than paying annually; check the difference.
2. Check whether the premium is fixed or flexible. Whole life premiums are generally fixed. Universal life premiums are flexible, and the amount that keeps the policy in force can change with the policy's charges. If you have universal life, request an how to request and read an in-force illustration showing how long the policy lasts at the current premium (why universal life policies lapse, and how to prevent it).
3. Look for loans. An outstanding policy loan accrues interest, reduces the death benefit and reduces the cash value available to you. Note the balance and the loan interest rate.
4. Find the dividend, if the policy pays one. A participating whole life policy may pay a dividend each year. Dividends are not guaranteed, and the amount is on the annual statement.
5. Note the cash value and the surrender value. These are in the statement or the policy's table.
6. Check for automatic features. An automatic premium loan, for example, can quietly pay premiums from the cash value as a loan.

A hypothetical Walter, 66, shows the effect of this audit. He owns a $100,000 participating whole life policy. His annual premium is $3,600. The statement shows an annual dividend of $1,100, a cash value of $41,000 and no loan. He has been paying the full $3,600 out of pocket and using the dividend to buy paid-up additions, which grow his coverage. Simply by changing the dividend option (step 2) he could lower what he pays out of pocket by $1,100 a year without changing the policy's structure, from $3,600 to $2,500, or about 31 percent. The price of that relief is that the additions stop, so his coverage and cash value no longer grow. The calculation: $1,100 / $3,600 = 0.3056, about 31 percent.

Step 2: Put the dividend to work on the premium

If you have a participating policy, you choose what the dividend does. The usual options are cash, premium reduction, paid-up additions, accumulation on deposit, and sometimes one-year term (life insurance dividend options: cash, paid-up additions and more). If you have been taking the dividend as cash or letting additions build, switching to premium reduction lowers your out-of-pocket bill at once. If you were taking cash, the net cost is much the same and the change mainly removes a payment going out and a payment coming back; the saving is real when additions or deposits were building instead.

Two cautions:

• The dividend is not guaranteed. If the insurer lowers its dividend scale, the amount that offsets the premium falls and you owe the difference. Walter should plan for the possibility that $1,100 becomes $900 in some year, which would raise his payment by $200.
• Dividends may be partly taxable if you take cash. A dividend is generally treated as a return of premiums until the total you have received exceeds your cost basis, after which the excess is taxable. Using the dividend to reduce the premium avoids receiving it as cash. A tax professional can tell you how your own basis stands.

Some policies also let you use accumulated dividends or paid-up additions to pay premiums. If you built up dividends on deposit or paid-up additions over decades, that pot can fund premiums for years. Ask the insurer for a projection showing how long the accumulated amounts would cover the premium. The projection is an estimate that depends on future dividends, so treat it as one scenario, not a promise.

Step 3: Pay the premium from cash value, carefully

You can often use the cash value to pay premiums, either through an "offset" arrangement or through policy loans. Both reduce what you pay from your pocket, and both reduce what the policy leaves behind. They differ in an important way: a loan accrues interest, while using the cash value directly (for example through a withdrawal or a premium offset arrangement) reduces the cash value by the amount used.

The danger with loans is compounding. Suppose Walter borrows $3,600 a year from his policy to pay the premium, and the loan interest rate is an illustrative 6 percent. The arithmetic after three years, ignoring any dividends:

• Year 1: borrows $3,600. Interest at 6 percent for the year on this amount is about $216 (assuming borrowed at the start of the year), so the balance at the end is roughly $3,816.
• Year 2: borrows another $3,600, bringing principal to $7,200. Interest on the balance of $3,816 plus the new $3,600 is about $7,416 x 0.06 = $445, so the balance is roughly $7,861.
• Year 3: borrows $3,600 again. Interest on $7,861 + $3,600 = $11,461 is $11,461 x 0.06 = $688, so the balance is about $12,149.

After three years the loan is about $12,149, which reduces the death benefit by that amount and grows each year. The point is not the exact figure. It is that borrowing to pay premiums feeds on itself. The policy loan calculator runs the same arithmetic with your own numbers.

Loans also carry a tax risk. Loans are generally not taxable while the policy stays in force, but if the policy lapses or is surrendered with a loan outstanding, the gain can become taxable income, even though no cash is received to pay the tax (how cash value is taxed: withdrawals, loans and surrenders). A quick illustration, again hypothetical: suppose a policy has a cost basis of $30,000, a cash value of $50,000 and a loan of $20,000. If it lapses, the insurer treats the policy as terminated. The amount received includes the $20,000 loan that is extinguished, plus the $30,000 net cash value: $30,000 + $20,000 = $50,000, less the $30,000 basis, leaves a $20,000 taxable gain, generally taxed as ordinary income. The person gets no check. Talk to a tax professional before letting a policy with a loan lapse.

If you have a loan already, ask the insurer about options to repay it, perhaps from dividends, and whether it offers a rider that guards against lapse when loans are large (overloan protection riders: how they prevent a taxable lapse).

Step 4: Lower the face amount

If the policy is bigger than you need, ask whether the insurer allows a reduction of the face amount. For universal life, reducing the death benefit usually lowers the cost of insurance and thus the premium needed to keep the policy in force. For whole life, some insurers allow a partial surrender or reduction, which cuts the premium and releases a proportion of the cash value; others do not offer it. Whether an insurer offers it, and on what terms, is in the policy and in the insurer's rules.

Say Walter decides a $60,000 benefit would cover his final costs and a modest gift. If the insurer allowed a reduction from $100,000 to $60,000, and the premium fell in proportion (an assumption; the actual change depends on the contract), the premium would fall to $3,600 x 0.60 = $2,160. Some of the cash value associated with the removed $40,000 might be paid to him, which may be taxable if it exceeds his basis. Ask for the proposed numbers in writing before deciding.

Pay attention to what a reduction does to dividends and guarantees. A smaller policy pays smaller dividends and has smaller guaranteed values. For a universal life policy, check that a lower death benefit does not cause the policy to fail a federal tax test; the insurer will tell you what the policy requires.

Step 5: Convert to reduced paid-up insurance

If you want lifetime coverage but cannot or will not pay premiums, the nonforfeiture options give you a way out. One is reduced paid-up insurance: the cash value is used to buy a smaller, fully paid-up whole life policy. No more premiums are due. The death benefit is lower than before, and it keeps a small cash value. On a participating policy, dividends may continue (nonforfeiture options: reduced paid-up and extended term).

The size of the paid-up policy is in the policy's nonforfeiture table, or the insurer will quote it on request. Suppose Walter's insurer quotes a paid-up amount of $62,000 for his $41,000 of cash value. That number is invented for this example; the real figure depends on age, policy and insurer. In that case he would give up $100,000 - $62,000 = $38,000 of death benefit and stop paying $3,600 a year. If he lives 20 more years, he would have paid $3,600 x 20 = $72,000 in premiums to keep the $100,000 policy going, compared with nothing for the paid-up $62,000. Which is the better deal depends on how long he lives and how much he values the extra $38,000.

Reduced paid-up is not reversible. Ask whether you can pay the premium for some more years and convert later, and compare it with the other nonforfeiture options.

Step 6: Consider extended term, and the cash option

The other two nonforfeiture options are worth understanding even if you do not choose them.

Extended term insurance uses the cash value to buy term coverage for the original face amount, for as long as the cash value will pay for it. Coverage then ends with no payout and no remaining value. It suits a person who needs the full death benefit for a limited time, such as to cover a debt, and does not need coverage forever.

Cash surrender pays you the cash value, less any surrender charge and loan, and ends coverage. It suits a person who no longer needs coverage, though part of the cash may be taxable if it exceeds the basis (surrendering a life insurance policy: what you get and what it costs).

Many policies set a default if you stop paying and say nothing, and the default is not always the one you would pick. Read the contract's nonforfeiture section and make the choice yourself within the stated window, rather than letting the policy decide.

Step 7: Ask for help from the insurer and a professional

Policy service departments can usually run illustrations of each option. Ask for, in writing:

1. the current cash value, surrender value and loan balance;
2. the paid-up amount and the extended term period you would get;
3. a projection of how long accumulated dividends would cover the premium;
4. what a face-amount reduction would do to the premium and cash value;
5. the effect of each option on dividends and guarantees.

If you work with an agent, ask for these as well, and ask the agent to show the comparison in dollars. Be cautious about any suggestion to replace the policy with a new one: a new policy starts new contestability and suicide periods, prices at your current age, and may need new underwriting (replacing a life insurance policy: when it makes sense). A fee-only financial planner, who is paid by you and not by a commission, can compare the options without a product to sell. For tax effects, ask a tax professional.

A decision order to follow

Put the steps together as a ladder, trying the least disruptive first.

1. Audit the premium, loans and dividends.
2. Redirect the dividend to the premium.
3. Use accumulated dividends or additions, if they exist, to pay premiums for a stated period.
4. Reduce the face amount, if the insurer allows it and the smaller policy still does the job.
5. Convert to reduced paid-up for permanent coverage with no further premiums.
6. Use extended term if you need the full amount for a limited time.
7. Surrender or sell only after you have compared the numbers and taxes.

Stop at the first step that makes the premium comfortable. Each later step gives up more.

For the budget side, the worksheet in Is the premium affordable? A fixed-income worksheet for older buyers measures the premium against your retirement income, and four retirees with an old policy: keep, shrink, convert or sell follows four households through the choices above.

Key takeaways

• Start with an audit of the premium, the dividend, the cash value and any loan before choosing anything; the numbers decide the path.
• On a participating policy, redirecting the dividend to the premium is the cheapest first move, but the dividend is not guaranteed.
• Borrowing to pay premiums compounds, and a lapse with a loan outstanding can create a taxable gain with no cash to pay it.
• Reduced paid-up gives lifetime coverage with no more premiums at a lower amount; extended term gives the full amount for a limited time.
• Ask the insurer for each option in writing, avoid replacing a long-held policy without a full comparison, and use a tax professional for the tax effects.