I wrote a post last Spring about how to dump your whole life policy, which also discusses WHETHER you should dump it, since the decision to get out of a policy is not the same as the decision to buy it in the first place. I often get feedback on what I write, especially if it is about whole life insurance, and this article led to an email exchange with an agent last fall who felt that I had left out a significant option for those wishing to get out of their policy.

Swap Your Permanent Life Insurance Policy For Another One?

His plan was to swap that whole life policy you hate so much for a different policy. Naturally, my reaction to this suggestion, from an agent no less, was that it sounded like a great way for him to make two commissions off my ignorance instead of just one. But I like to think I’m open-minded, so I heard him out. Here was what he was really suggesting.

1035 Exchange Your Cash Value Into a Universal Life MEC

His point was to look at the reason why people want out of their whole life policies. Often, it is because they don’t want that reminder sitting there that they used to be financially stupid. But his point is correct, that what people really don’t like about them is that they are forced to pour good money after bad. There is an ongoing payment required each year. It might be for 20 years, to age 65 or even until death. It isn’t that they don’t like or value the permanent death benefit, it’s that they have a better use for their money now.

They might want to use that money to pay off student loans, purchase an investment property, max out a retirement account, pay for college, buy a boat or pay off a mortgage. But they can’t, because every year they’ve got to come up with $1,000, or $10,000, or $25,000, or $100,000 to pay that premium, year in and year out for decades. So what’s the solution? A single premium insurance policy paid for using the cash value via a tax-free 1035 exchange. Voila- no more payments due ever, no taxes due, and you still get that permanent death benefit and probably some asset protection benefits, depending on your state. What’s more, he argued, is you can get MORE of a death benefit by doing this. That part, of course, sounded a little squirrelly to me, so I made him prove it with some illustrations.

The main problem with investing in insurance is you have to quit doing stuff that keeps you from getting insurance at a decent rate, like this.

The main problem with investing in insurance is you have to quit doing stuff that keeps you from getting insurance at a decent rate, like this.

The Illustrations

You’re really comparing three things. First, a whole life policy on which you continue to make the premium payments. Second, a whole life policy on which you simply allow the policy dividends and cash value to make the payments (keep in mind this option is only really available for policies you’ve had for a long time, like 20 years or more.) Third, a single premium universal life policy. The idea is that you have a healthy, 50 year old non-smoking male who has had a whole life policy for 20 years and has $27,255 of cash value in it available to exchange. Where does that $27,255 of cash value come from? It came from the 20 year projected cash value for a Mass Mutual Whole Life Legacy 100 policy bought on a healthy 30 year old non-smoking male. The premiums on that policy were $1,028 and the face value was $100K. After 20 years, you’ve paid in $20,560 and have a cash value of $27,255, representing an internal rate of return of 2.61%. (Again, this is projected, not guaranteed.) Meanwhile, your death benefit has increased to $119,718.

Option 1 Keep the Original Policy, Keep Making Payments

At age 90, it is projected that you’ll have paid in $61,680 in premiums and have a cash value of $369,709 and a death benefit of $428,467. The IRR on the cash value would be 4.92% per year. But you’ll have had to make another 40 years of payments, which you don’t like.

Option 2 Keep the Original Policy, Stop Making Payments

Now, instead of your dividends going toward paid up additions, they are used to pay the premiums. At this point, the dividends precisely equal the premium (now you know why the numbers above aren’t so round.) So what do you get? You never make another payment and you get a permanent death benefit of $119,718. Granted, if the dividend rate goes down the policy will start shrinking, and if they go up you can either spend the difference or you’ll have a larger death benefit.

Option 3 1035 Exchange to a Single Premium Universal Life Policy

We’re using a John Hancock Protection UL policy paid using a single premium of $27,255 on a healthy 50 year old non-smoker. So you pay a single premium, and you have a permanent death benefit. How much is that death benefit? $186,965, or 56% higher than under the whole life policy. With this particular policy, that death benefit is only guaranteed for 24 years, so there is some risk there (i.e. the risk that you’ll have to start making payments again in the future), but it is very similar to the risk of option 2 anyway (i.e. that dividend/interest rates fall dramatically.)

So you not only get to quit paying premiums, but you also get a larger death benefit. Plus your agent gets to make a new commission. Everybody is happy- you, your heirs, and your agent.

[Update prior to publication: I asked the agent to look into what kind of a guaranteed (to death) death benefit could be had, and this was his response:

I called John Hancock and they have no policies that guarantee a death benefit for life.  I am still checking around, but so far the GULs don’t give a big return.  Omaha, MetLife, Protective Life, all look pretty bad, less than $100k return on the $27k.  The other illustration I sent last time from Prudential looks like it’s ok comparably.  $27k buys $144k in death benefit guaranteed to age 84 I believe.  I am going to get more quotes, but I am not holding my breath here.  In general, since we’re switching to a UL, it’s tough to get a guaranteed death benefit. 

He did eventually find one that guaranteed $114K until death, but that’s less than the WL policy’s $119K, so it’s pretty hard to get excited about.]

The Downsides

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The downsides of doing this exchange are several fold. First, single premium insurance policies are by definition a MEC. That means you can’t borrow from them tax-free. The death benefit is still income tax-free to your heirs, but you can no longer borrow from the policy to bank on yourself or to pay for expenses in retirement. You’ve essentially committed to leaving this money as part of your estate.

Second, there is an opportunity cost. If you took that money out, paid any taxes due on it (or claimed any tax loss), and invested it in stocks or real estate, you have a decent chance of leaving more to your heirs in the end, plus you have the flexibility to spend some of it yourself if you need to.

Third, if you go for a guaranteed universal life policy, you may be better off just getting the whole life policy to the point where the dividends can cover the payments. That’s pretty easy to do if you’ve had it for a couple of decades already, but not such a great option if you’ve only been paying for 5 years.

What do you think? Would you consider this a viable option for dumping your whole life policy? Do you see any significant advantage over keeping the whole life policy and just paying the premiums with dividends in this scenario? Comment below!