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A Connecticut caller named Christine told The Ramsey Show on Oct. 1 that she and her husband were each paying $200 a month for an indexed universal life policy with a $250,000 death benefit. (1)
Co-host Rachel Cruze didn’t hold back. She called it “a crappy, crappy product.” (1)
“Always keep your insurance and your investments separate,” Cruze said. “The moment they combine them in a product like this, you get a crappy rate of return and you pay a lot for not a lot.” (1)
Dave Ramsey has been even harsher. On a Sept. 11 call about an indexed universal life policy another couple had been sold, he said, “The product is absolutely horrendous. It’s basically the payday lender of the middle class.” (2)
I’ve been a CPA since 1981, and on the big idea, I agree with them. But if you own one of these policies, how you get out matters as much as whether you get out. Here are five things to know before you cancel.
1. They’re right: insurance and investing usually work better apart
Universal life is permanent coverage with a cash account, according to the National Association of Insurance Commissioners. (3) The indexed version, or IUL, doesn’t let you pick investments. Instead, it follows a set stock index, such as the S&P 500, according to FINRA, the brokerage industry’s regulator. (4)
These policies also offer a guaranteed minimum interest rate, the NAIC says. (3)
That sounds like the best of both worlds. The catch is cost. “Term insurance is generally more affordable than permanent insurance, particularly in the early policy durations,” the NAIC says. (3)
My read: most families are better off buying cheap term coverage for the years someone depends on their income, and investing the difference in a low-cost retirement account.
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2. First ask whether you need life insurance at all
Here’s the part of the call I think matters most. Christine and her husband have no children. (1)
In my view, life insurance exists mainly to replace income someone else relies on. No kids, no one depending on your paycheck, no big debt a survivor would be stuck with? You may need little coverage, or none.
If someone does depend on your income, term coverage is generally the more affordable way to protect them, as the NAIC notes. (3)
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If you decide to drop coverage you don’t need, put that money to work. Christine and her husband were paying $400 a month combined. (1) Redirected into an investment account, that’s real money over a decade.
Quick gut-check — if your money advice is coming from random online influencers, you’re playing a dangerous game. I’ve been a CPA since 1981 and writing about money since before the internet existed. Sign up for the free Money Talks Newsletter and get expert advice that’s been tested by time.
3. Don’t drop the old policy until the new one is in force
Because this couple has no children, Cruze told them they could cancel and replace “back to back.” (1)
If anyone depends on your income, be stricter.
With children at home, buy the term policy first and cancel the old one only after the new coverage is active, because underwriting can take weeks and a gap leaves a family exposed if a health issue surfaces. (1)
4. Surrendering can trigger a tax bill
This is where a CPA earns his keep. When you surrender a life insurance policy for cash, proceeds that exceed your cost are taxable income, according to the IRS. (5)
Your cost is the total premiums you paid, minus any refunded premiums, rebates, dividends, or loans you neither repaid nor previously included in income. (5) That loan piece matters: borrowing against a policy can shrink your cost and raise your tax.
In plain English: if what you get back is less than your cost, there’s usually no tax. If it’s more, the gain can be taxable income in the year you cash out.
Before you surrender, ask the insurer for two numbers in writing: your net cash surrender value and your cost in the policy (sometimes called your “investment in the contract”). (5) Then you’ll know whether you’re facing a tax bill.
5. You may be able to move the cash value tax-free
There’s a tool in the tax code for this. Under Section 1035, no gain or loss is recognized when you exchange a life insurance contract for another life insurance contract, an annuity or a qualified long-term care insurance contract. (6)
For a couple with no kids to protect, that last option deserves a look. Medicare doesn’t pay for long-term care, also called custodial care, according to Medicare.gov. (7)
Rules and products vary, and an exchange has to be done correctly to keep its tax-free treatment. That’s a good reason to have a pro look at the numbers.
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My honest take
The Ramsey Show got the big picture right. Buying life insurance as an investment too often leaves people with too little of both.
But canceling is a decision, not a plan. Check whether you need coverage. Line up the replacement first. Know your surrender value and your cost. And if there’s a gain, find out whether an exchange beats a cash-out.
Getting into a bad product took one signature. Getting out right takes a little homework.
Sources: 1. 24/7 Wall St. via AOL; 2. 24/7 Wall St.; 3. National Association of Insurance Commissioners; 4. FINRA; 5. IRS; 6. 26 U.S. Code § 1035, via Cornell Law School; 7. Medicare.gov
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