Life Insurance For The Living
Let me open up with a simple question, how much of your FEGLI coverage is available for you to access while you still have a pulse?
Some of you may scoff and say, “Duh, NONE! It’s life insurance, clearly it is not meant for me!”
Now, while we are all well aware of the traditional application for life insurance… What if your life insurance could also provide coverage for you, the owner, during your lifetime? What if there was a way to access a portion of your Death Benefit in the case of a non-fatal emergency? There is! Strategies designed using Living Benefits do exactly that.
Living Benefits refer to the set of policy riders that provide the ability for a life insurance policy owner to access a portion of their life insurance Death Benefit in the event of a qualifying emergency. These progressive features are more important today than ever before because of the exponential advances in medicine and health care over the last few decades. Simply put, we are now surviving many of the illnesses, the diseases, and other traumas that would have been fatal to earlier generations. In fact, they anticipate that the first person who will live to 150 years old… has already been born! These advanced medical practices are saving lives at an unprecedented rate, yet surviving these previously fatal events can have many financial implications and secondary complications that aren't always apparent. Lets look at some real world gaps in protection that Federal Employees face, even when “fully covered” by the FEHB and FEGLI.
Case in point: The only aspect of your FEGLI Death Benefit that is available to the you while you are still breathing is the Basic Coverage (Salary rounded up to nearest thousand + $2,000), which is only accessible if you have a Terminal Illness with less than 12 months to live…
What if, at age 58, you had a severe heart attack? The hospital bill is largely covered by your FEHB, but perhaps you are unable to go back to work for 8 months while recovering. Your Federal Disability benefit covers 60% of your “HI-3” salary but the Federal Disability Benefit ONLY begins if the disability will last longer than 12 months (https://www.opm.gov/forms/pdfimage/sf3112-2.pdf ). If you are only out 8 months, you will not receive a dime from this benefit. Now, since the heart attack is not considered a “Terminal Illness” there will be a grand total of $0 available from your FEGLI coverage. Uh-oh, in today’s America of processed meats and fast food,
how likely is it that you know someone who may see this scenario?
So think of that friend, what major asset would that federal employee most likely have to turn to in order to find 8 months of income replacement in a scenario like this?
Many Feds look to their TSP when forced into these tricky situations, so let’s explore the unintended consequences of accessing these funds early in a pinch. Our unfortunate Fed in this example would qualify for a “Financial Hardship In-Service Withdrawal” from the TSP (form TSP-76). While this grants access to the TSP funds, there is still the issue of having Traditional TSP disbursements recorded as taxable income - and since this individual is under 59 1/2 years old, they will also incur the 10% Early Access Penalty and state income taxes (for states that charges them). Once we start calculating taxes and penalties, it becomes pretty easy to see why about 50% of bankruptcies are due to medical emergencies according to Harvard studies (http://content.healthaffairs.org/content/suppl/2005/01/28/hlthaff.w5.63.DC1), doesn’t it?
So let’s assume that this individual needed an after-tax disbursement of $50,000 to replace 8 months of their income while they are recovering. Since they will not receive any disability benefit nor aide from the FEGLI coverage, we need to get all $50,000 from the TSP -despite having to fork over 25% in income taxes, the extra 10% Early Access Penalty, and 7% for our assumed State Income Tax before we would actually receive a dime.
So, how much would have to be withdrawn in order to pocket the $50,000 we need?
$86,206! (Note: Your situation may very well be different, this is a hypothetical example)
In many households, a taxable disbursement of this size could even bump the gross household income received for that year over the threshold of a higher tax bracket, causing this family to pay a higher % in income taxes for every dollar of income received that year (not just the disbursement amount). Additionally, taking a hardship withdrawal means you are not allowed to contribute to the TSP for 6 months. If you were previously putting in 5% in order to receive the full 5% match from the government then together that means that prior to the hardship withdrawal a total of 10% of your salary was going into the TSP each paycheck. For the 6 months after the hardship withdrawal that number goes from 10% down to the 1% auto-contribution from the government. Who likes passing up free money?
But the biggest issue with this approach is that it drastically reduces the Fed’s main retirement asset (the TSP), and it does so at a time in their career (age 58) when they simply don’t have enough time left to build the TSP back. This means that we have severely hindered the TSP’s ability to provide the necessary growth over the next 20-30 years to properly fund our retirement. Remember the story about the goose that lays the golden eggs? You can sell the golden eggs each and every time they are laid, but you can only sell the goose that lays them once! The same concept applies to the principal (goose) and the gains (golden eggs) within your TSP.
If this individual had a life insurance policy with a “Critical Illness” rider, they would be able to access an accelerated portion of that death benefit (tax-free) in order to replace the missing income during the time that they recover from the heart attack. This is done without having to drastically reduce their TSP balance and thus does not lower the TSPs ability to generate adequate income throughout their golden years. This is also accomplished without incurring the big additional expense of purchasing a separate Short-Term Disability Insurance policy.
The coverage provided by these Living Benefit Riders is flexible enough to cover many different “critical illnesses”, which is essential when planning for the future if your crystal ball is not working. In addition to being a no cost rider, the “Critical Illness” rider is not limited to one specific disease.
When utilized a Critical Illness Benefit provides a portion of the policy’s Death Benefit as a tax-free lump sum if the insured is diagnosed with a critical condition such as: stroke, heart attack, cancer, ALS, kidney failure, and blindness due to diabetes.
In contrast, there is the narrow applications of policies that are designed to protect the owner from only one issue, such as is the case with cancer policy coverage. The statistics on cancer in the US are quite alarming, but in spite of the need for protection, cancer policies are so expensive and have such constrictive regulations that people often cannot justify the cost. Most cancer plans fall under the “use it or lose it” design, which means regardless of the amount of coverage you purchase or the amount of premium you pay in during your life time if you don't use it, you lose it. In other words, hypothetically let’s say you pay $2,500 a year for 20 years to have this cancer protection but then you are walking down the street and get hit by a bus… well then that $50,000 was lost. Now, as you can see in the list of “Critical Illnesses” above that “cancer” is a qualifying diagnosis to trigger the benefit from this free rider.
Now, to clarify, these riders are additions to the life insurance policy that is intended to provide for your family in the case of your passing. The specifics of these Living Benefits vary by company, insurance type, and even geographic region but generally they are added at no additional cost! These riders are flexible in their application and allow access to a tax-efficient, highly leveraged disbursement of emergency funds. Including Death Benefit access during your lifetime allows these riders to be applied in similar fashions to the alternative policy types described in the comparisons above. Now while the use is generally comparable to that of a cancer policy or short-term disability plan, they are not meant as an apples-to-apples replacement of those coverages when the specific qualifying event occurs (ie. a cancer diagnosis for a cancer policy). But because we cannot predict what is to come, we need the money we put towards insuring our future to be applied as efficiently, effectively, and flexibly as possible. When we revisit the fact that these are no cost riders on your Life Insurance policy, would you say they qualify as an effective use of those premium funds?
As you can see, these are complex topics with many implications and ramifications, so it is absolutely imperative that you work with a federally focused professional that understands your current benefits package when designing a comprehensive protection plan for insuring your future.
In part 2 of this series we will discuss Chronic Illness living benefit riders and discuss the general application of Federal Long Term Care Insurance, Medicaid Spend Downs, and some of the tax implications of different approaches to the issue of affording elder care.
Disclosure: This publication is meant to be an educational overview emphasizing the need to review your personal situation with a Federally Focused Financial Advisor or a Chartered Federal Employee Benefit Consultant in order to address the topics discussed above.