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Q&A: Tax-friendly policies
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October 19, 2000: 10:30 a.m. ET
Tips on tax-free withdrawals and health insurance after divorce
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NEW YORK (CNNfn) - When you factor in the high commission costs and fees, the tax advantages of a Variable Universal Life insurance policy may not be worth it. Also, if you're getting a divorce and are covered under your spouse's health plan, federal law allows you to retain coverage at a reasonable cost for at least 2 years.
Navigating the ins and outs of your insurance policy can be tricky business. As such, consumers frequently fail to realize they're underinsured, or overinsured, as the case may be, until it's too late.
Here's your chance to find out the facts from a group of industry experts at the Consumer Federation of America (CFA). Questions related to senior health insurance, including Medicare and long-term care policies, are fielded by Bonnie Burns, director of consumer education for California Health Advocates, the state's insurance counseling program. Check back each week to read theatest Q&A on our Insurance page.
Question: A popular insurance policy is the Variable Universal Life (VUL). I heard from someone saying that you can set up these VULs with a majority of the premium in a security-based sub account and then some for term insurance (varies annually). Then, when you are ready to retire (at age 65), I understand you can draw monthly distributions, which would be ALL tax-free.
Is there such as a thing? I am not talking about borrowing against the cash-value. I would think that part of the distribution would be taxable interest/dividends deferred) and part non-taxable (e.g., premium). - Margaret, DMS/MDS
Answer: It is true under current law that one may make tax-free withdrawals and/or tax-free loans within limits and provided the policy premiums are not excessive relative to the face amount. (One should realize that proceeds from other loan sources, such as home equity loans, are also tax-free.) And, the array of commissions, fees, premium loads, and asset charges for these policies can be high, raising the question of whether the policy's tax-advantages are worth it. It is also important to understand that for most buyers to receive a life policy's maximum tax advantages one must keep it in force until death to avoid a potential taxable gain (ordinary rates) on surrender. - Bob Hunter, CFA
 Question: I have a friend who is initiating a divorce from her husband. She does not work and is covered under her husband's health insurance from work. After the divorce, will she still be covered for a short while? Could you list the options that she has? Thanks - Jenn
Answer: Your friend should be covered for at least 2 years under federal law for a cost about the same as the employer pays for the coverage - so that's a good deal. - Bob Hunter, CFA
Question: Could you please explain Universal Life policies? - Cindy
Answer: UL is technically "flexible premium whole life." Whole life usually has fixed level premiums much higher than term life insurance with the excess premiums building cash values over time. UL premiums can vary within a broad range and can be changed at will by the policy owner, including paying zero if the policy has enough cash value to cover the monthly deductions for expenses and death protection. Also, the face amount may be changed up or down, but this advantage is limited: an increase will require evidence of good health and will incur new commissions while a decrease will usually mean a pro-rata surrender charge. In general, CFA prefers WL to UL because in the long run it can offer better value. - Jim Hunt, life insurance actuary for CFA
Question: How are the internal charges calculated for whole life policies, and why can't they itemize the internal charges? It seems as if they group all policy expenses together. Bottom line: How do insurance companies come up with their projected dividends for their whole life policies? - Keith
Answer: One of the reasons we tell people to avoid cash-value policies is they are so complex that even actuaries can't tell if a policy is good without running a computer program to analyze it. The best answer I can give is to submit any policy to the Consumer Federation of America for review. We analyze the true investment return, or interest rate, on a cash value policy and will make alternate recommendations where appropriate. It costs $45 for this service. - Bob Hunter, CFA
Question: What alternative is there to state-provided insurers of last resort for wind and storm coverage? In Florida the cost is prohibitive. What else is there? - Unnamed
Answer: Not much, yet, although the market seems to be easing. Hurricane Andrew sent the insurers into a bit of a rampage, with threats to cancel people in Florida and massive rate increases. The rates are out of line with reality. The state insurance commissioner tried to hold the line on rates, but could not because the legislature caved into the insurance companies and took away from the commissioner the ultimate power to control prices. So, for now, shop and hope. - Bob Hunter, CFA
Question: My father entered into a policy with CrownLife in the mid- to late-1980's in order to ensure that my mother would have a lump sum of money to invest upon his passing in order to supplement Social Security and their pension. When he was sold the policy, he was told that he would only have to pay his premium for a few years and after that the dividends would be substantial enough that he would not have to pay anything. Things didn't work out that way, but that is another story.
He has been paying $7,234.80 per year on the policy. The death benefit today is $237,054. The cash value I'm told is $103,274.49, of which $34,335 is the result of paid up additions (in other words the cash value is $69,160 before the paid up additions).
 I recently inquired with the company as to whether my father's payment option could be changed so that the dividend portion of the $7,234.80 premium (of approx. $3,600) could be applied to pay $3,600 of the $7,234.800 bill currently due -- I understood that this would result no paid up additions this year and no further growth in the ultimate death benefit for having done this. This was okay with my father, and they said we could do this. But, the amount applied to the $7,234.80 would be something more in the neighborhood of $2,600. I think the lady at CrownLife did not do a great job of explaining, plus I am a novice in terms of my understanding to begin with.
I have a feeling that this Company (which tricked my father on the sales pitch) has been using my father's payments (specifically, the amount over and above what it costs actuarially to maintain a death benefit of $190,000) for their own benefit. I think my father would have been better off through the years to pay only the amount necessary to maintain the $190,000 policy and invest the rest of the premium himself. But again, it seems the dividend portion of the $7,234.80 is $3,600 only if you apply it to buy paid up additions, and $2,600 if you apply it to premium reduction. Seems like they've got my father locked into giving them the full $7,234.80 each year. - John
Answer: Many were sold these "vanish premium" deals with wholly inadequate disclosure as to the risk that more premiums would be required than illustrated at time of sale. There has been much litigation on the point. The reason for needing more premiums is simple: when sold, probably in the late 1980s or early 1990s, interest rates were very high and dividend scales were also high. As interest rates declined throughout the 1990s, the portion of the dividend that allowed Crown to pass through its high investment earnings declined substantially, resulting in more premiums due.
As a rough rule of thumb, for every 1% decline in the "dividend interest rate (DIR)," 2 more premiums were required to make the policy "self-sustaining." Many dividend scales DIR's are now 3% lower or more than in the late 1980's.
It can also be true, however, that the policy is now quite valuable, relative to the current market, something that could be learned from a CFA analysis. This is not to say that the policy should be kept if the insured is in excellent health, as policies can be transferred to another insurer without incurring tax if done carefully and, preferably, without incurring full commissions on the new policy.
There is also the option to take a reduced paid-up policy -- lower death benefit, no more premiums. This can be an attractive option for those who definitely want to pay no more premiums, are in good health, do not need the lost insurance, and who would be subject to a taxable gain on surrender. 
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