In Brief
Being diagnosed with a terminal illness is a profoundly emotional event that also raises many important financial questions. Financial planners can help provide the answers. The authors provide an overview of the financial considerations applicable to individuals facing a terminal illness, including the taxation of disability and life insurance and the necessity of comprehensive estate planning.
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When a person is terminally ill, the emotional impact on the individual and caregivers cannot be overstated. Nevertheless, there also are financial implications to the diagnosis that cannot be overlooked. Financial advisors can help handle these details, for the ill individual as well as a spouse, children, or other related parties. Astute planning can help the dying individual be physically comfortable and retain assets that can be passed to loved ones.
Broadly, financial planning during a terminal illness falls into two stages. The first is during the illness itself, when current cash flow is maximized to cover the medical and institutional expenses that are likely to arise. Estate planning becomes more urgent in the second stage, when death is imminent. Ideally, sufficient funds may be retained for wealth transfer, which should be structured for a minimum of time and conflict.
Disability Coverage
Whether the terminally ill person is still in the workforce can make a significant difference in terms of cash flow. Group disability benefits may be available from an employer, and workers compensation or Social Security disability payouts might be possible. Some individuals also have personally owned disability insurance, instead of, or as a supplement to, group coverage.
Disability benefits may (or may not) be considered taxable income. If an individual pays for disability insurance with her own after-tax dollars, any benefits she receives will be tax-free. If an individual’s employer pays the premiums for the disability insurance, however, she must report any disability benefits received as taxable income to the IRS. States typically follow this tax treatment as well.
Thus, if a disabled individual has group coverage at work and pays the premiums, any benefits received will be taxfree. This is true even if the payments are made through payroll withholding, as long as the worker pays income tax on the money that is withheld. If there is a cost-sharing arrangement for disability insurance, the employee will have a proportionate amount of tax-free income.
Example.
Assume Alice is covered by group disability insurance that costs a total of $50 a month: $25 from the company and $25 from Alice via payroll withholding. Here, Alice pays for 50% of the cost of the insurance, so any disability benefits she receives from the policy will be 50% taxable and 50% tax-free. (If Alice has requested that the disability premiums paid by the employer be treated as additional taxable compensation, all of the benefits will be tax-free.)
Or, suppose Alice acquires disability insurance with outlays from her company’s cafeteria plan. Permitted under Internal Revenue Code (IRC) section 125, this plan allows Alice to withhold some of her paycheck earnings to pay for certain benefits, such as disability insurance, with pretax dollars. As this arrangement avoids income tax on money used for premiums, any benefits will be taxable. (If Alice has arranged for her disability insurance outlays in the cafeteria plan to be treated as taxable compensation, any disability benefits will be tax-free.)
If a terminally ill person has bought individual disability insurance with after-tax dollars, as is typical, no tax will be imposed on any benefits received. Therefore, in order to report any disability insurance payouts accurately and pay whatever tax is due, it is vital to know how the premiums have been paid.
Life Insurance before Death
If the terminally ill person has left the workforce, different sources of cash flow may be required. After age 59½, IRAs, 401(k)s, and other retirement accounts usually may be tapped without incurring the 10% early withdrawal penalty. Income tax probably will be triggered, but that may not be a significant issue for people who otherwise are short of cash.
Another source of cash for older patients may come from a life insurance policy that has been held for many years. Some policies are structured so that the death benefit can be partially paid out to the insured individual if certain health-related tests are passed; this might be possible even in case of a terminal illness. Typically, the policy will include a rider offering a lifetime payout if the insured individual has a life expectancy of less than 24 months, as certified by a physician.
Depending on the specific policy held by the terminally ill person, other ways to raise cash might be available. That individual might be able to surrender the policy for its cash value, withdraw money, borrow against the policy, or exchange it for an annuity. Some policies have a “disability waiver of premium,” so the policy can remain in force if the insured individual becomes disabled. The money not required for ongoing insurance premiums can then be used for other needs.
Given that Americans are living longer than ever before, the need for LTC is rising, and it usually must be purchased prior to the onset of an illness.
Another possibility is to sell the policy. Individuals and investor groups may offer to buy it, pay the required premiums as long as the insured individual is alive, change the beneficiary, and eventually collect the death benefit. In some circumstances, this will provide more money to the seller than other alternatives.
Some life insurance policy sales are known as viatical settlements. These usually take place when the seller has less than two years to live, as certified by a doctor, and the funds received are not subject to federal income tax. In some cases, people who are chronically rather than terminally ill can avoid tax on these transactions if the money received is used to pay for qualified long-term care. In order for the proceeds to be tax-free, the buyer generally must be a licensed or registered viatical settlement company.
Another consideration is long-term care (LTC) insurance. When purchased, such insurance tends to include those items not typically paid for by standard health insurance or Medicare and Medicaid. Although age is not controlling, it is one element considered, along with whether the individual can perform day-to-day tasks or activities, such as cleaning, eating, and standing/walking.
Given that Americans are living longer than ever before, the need for LTC is rising, and it usually must be purchased prior to the onset of an illness. LTC will cover assisted living, homecare, hospice, and additional medical supplies, such as walkers or commodes. Financial planners are increasingly suggesting LTC as part of a general estate plan in order to shelter assets and achieve a tax deduction, as LTC benefits are generally not considered income. Businesses may purchase LTC plans for employees and receive sizeable deductions.
There are two types of policies offered. Traditional LTCs are most common and are paid on an annual or semiannual basis; if LTC is not needed, it is retained by the provider and not returned unless the contract includes a rider stating some other mechanism. Hybrid, or combination, LTC policies work with existing life insurance plans.
With respect to tax benefits, tax-qualified policies require the individual to need care for more than 90 days and be entirely unable to perform predetermined tasks or activities of day-to-day living without help. A severe cognitive impairment could also trigger the LTC to be tax qualified. In either event, a physician must evaluate the individual.
Non–tax-qualified LTCs are triggered only when medically necessary, meaning that the individual’s physician, or that of the LTC provider, will proclaim the individual needs care for whatever reason. These policies have not been elucidated as succinctly as tax-qualified policies and may be more flexible.
Whole life insurance is another policy worth considering when facing terminal illness. Whole life insurance is a policy guaranteed to remain in place for the duration of the individual’s life as long as premiums are paid, or to the date of the policy’s maturity. Given their breadth, whole life insurance premiums tend to be much higher than term life insurance. Whole life insurance is categorized as a cash value policy, like universal, variable, and endowment policies.
Typically, the benefit of a whole life policy is the contracted number. If the policy is participating, however, the benefit will increase or decrease with dividend values or outstanding policy loans. Universal life policies, on the other hand, may be altered to pay more than the initially stated amount, but rarely guarantee lifetime coverage.
Whole life insurance matures at death or the policy anniversary nearest age 100, whichever comes first; covered individuals or their beneficiaries then receive cash. Given longer lifespans, maturity ages have been increasing to as much as 130 years, which allows the death benefit to be tax-free. Any matured payments might, however, incur tax obligations.
If a whole life policy is cashed out before death, any gain over total premiums paid will be taxable as ordinary income. Individuals can instead elect to take cash as a loan against the death benefit, which is free from income tax as long as the policy remains. The interest on such loans is determined by the provider, as are the terms of repayment.
Taxable Transactions
Sales of life insurance policies that do not qualify as viatical settlements are known as life settlements. Here, a sale may generate a tax obligation.
Example.
Len bought a life insurance policy years ago, when he and his wife started a family. Len has paid a total of $200,000 in premiums. Len is now a widower and terminally ill; his grown children do not have a pressing need for his life insurance benefits. Therefore, Len sells the policy to an investor group, receiving $500,000.
If a whole life policy is cashed out before death, any gain over total premiums paid will be taxable as ordinary income.
Intuitively, Len would owe tax on a $300,000 gain: he paid in $200,000 and received $500,000. In Revenue Ruling 2009-13, however, the IRS stated, “To measure a taxpayer’s gain upon the sale of a life insurance contract, it is necessary to reduce basis by that portion of the premium paid for the contract that was expended for the provision of insurance before the sale.” To comply, Len would have had to subtract the cost of life insurance protection from his basis in the policy to arrive at the taxable gain, complicating the calculation.
Fortunately, the Tax Cuts and Jobs Act of 2017 (TCJA) reverses Revenue Ruling 2009-13. Thus, Len’s basis would be the $200,000 he paid in premiums, and his gain on a $500,000 sale would be $300,000. Continuing the above example, assume Len had $325,000 of cash value in his policy. The $125,000 gap between the premiums he paid ($200,000) and his policy’s cash value ($325,000) would be taxed as ordinary income. The other $175,000 of Len’s profit (after subtracting the $125,000 taxed as ordinary income from his $300,000 gain) would be taxed as a long-term gain. The 3.8% surtax on net investment income might also apply.
Terminally ill individuals who are thinking of selling a policy should calculate the after-tax proceeds and compare them to the after-tax cash available from other ways to tap their life insurance. Policyholders may be able to withdraw money from and borrow against permanent life insurance tax-free, but excess policy loans or withdrawals could generate a tax obligation after a policy lapse.
Of course, selling an insurance policy on one’s own life involves more than cash flow and taxes. The seller must be comfortable that unknown investors, rather than loved ones, will collect a benefit upon death. If that is acceptable, will buyers be interested? It depends on the seller’s life expectancy, as indicated on medical reports, which must be submitted. Buyers usually prefer policies held by people age 75 or older; for younger sellers, it is probably necessary to show a severe medical condition. Furthermore, buyers generally prefer cash value policies (i.e., whole life, universal life, variable life). Term life policies may be acceptable if they are convertible to some form of cash value policy.
Estate Planning
Regardless of whether cash flow is needed for medical expenses and other outlays, people who are terminally ill will want to be sure that their assets smoothly pass to loved ones or favored charitable causes. Thus, a thorough estate planning review can help put the patient’s mind at ease.
In 2018, the federal estate tax exemption is $11.2 million for single taxpayers and $22.4 million for married couples. Such a generous exemption means relatively few people will leave an estate that is subject to federal tax; consequently, many terminally ill people below those asset levels may ignore estate planning.
Nearly half of all states impose estate or inheritance taxes, however, so it is vital to check with a tax professional to see if planning can save money for heirs. Even if no tax will be due, skimping on estate planning can be a mistake. As part of a thoughtful estate plan, the terminally ill person should have a will; otherwise, the estate assets will be distributed as per state law. Assets might wind up in the wrong hands after death, and there could be unnecessary costs or delays in wealth transfer.
Example.
Assume that Lou is terminally ill. He separated from his wife years ago, but there was no divorce or formal separation decree. If Lou dies without a will, then under the intestacy laws of many states, his wife will receive ⅓ of his assets—more than he may have wanted. On the other hand, if Lou is living with someone but not legally married, dying intestate could deprive that partner of any inheritance whatsoever. No matter what the situation, it is vital to make sure that a terminally ill individual has a will with desired bequests, drawn up by an experienced attorney.
A comprehensive estate plan consists of more than a will. If the terminally ill person holds any assets as a joint tenant with right of survivorship (JTWROS), those assets will pass directly to the surviving co-owner after the first death, regardless of what it says in the decedent’s will.
Example.
Assume that Thelma and her sister Molly bought a vacation home when they were both single and titled it as JTWROS. Thelma and Molly each married and had children; over the years, as their families used the vacation home, it increased in value.
Now suppose that Thelma grew seriously ill and eventually died. In her will, Thelma left her assets—including her share of the vacation home—to her husband and their children; however, the sisters never changed the title of the cabin from JTWROS. Consequently, the home will become fully owned by Molly, rather than 50% owned by Thelma’s heirs.
In some situations, there are good reasons to title property as JTWROS. Assets held in this manner will go to a surviving co-owner without going through probate, which can save time and money. Nevertheless, individuals who are terminally ill should review property ownership, checking to see how it will be handled at their death.
It is unlikely that anyone, including someone who is terminally ill, will be able to cover everything in a will or transfer everything to a trust.
Similarly, assets such as IRAs, employer retirement plans, and life insurance policies often will not go to heirs under a decedent’s will, but rather will pass under a beneficiary designation. After a divorce, an ex-spouse might inherit a retirement account or life insurance death benefits if still listed as beneficiary. Thus, a review of beneficiary designations is vital.
Moreover, assets held in trust may pass under the terms of the trust without going through probate. If a terminally ill individual moves assets into a trust, not only can probate be avoided, the threat of the will being contested might be reduced.
Filling the Gaps
It is unlikely that anyone, including someone who is terminally ill, will be able to cover everything in a will or transfer everything to a trust. Where can valuable papers be found? Who will care for a beloved pet?
Therefore, a terminally ill individual might create a letter of instruction to supplement other estate planning documents. This is where financial details can be described, such as savings and investment accounts, location of real estate deeds and life insurance policies, and contact information for accountants, attorneys, and other advisors. The letter can also include computer user names, passwords, PINs, and other information necessary for access to electronic records. Funeral and burial wishes can also be provided here, along with information about any advance payments that have been made. Of course, the terminally ill individual’s close relatives and executor should know where to find the letter.
A letter of instruction can also supplement a will by providing details about how the terminally ill person would like personal possessions to be distributed. One approach is to say that certain family members can decide among themselves who will inherit items such as artwork, furniture, and jewelry, with the executor resolving any disputes. Alternatively, this letter might specify that valued heirlooms will go to specific persons. Are the terms of a letter of instruction legally binding? Generally, no. The letter is more of a roadmap to help survivors locate and distribute assets. Many states, however, recognize a “property memorandum” or a “memorandum of tangible personal property items.” This document might list specific articles owned by the terminally ill individual and designate specific recipients. If that individual refers to such a memorandum in a valid will, the memorandum may become a legal document.
Other Steps
Additional legal documents, such as a power of attorney, may be necessary for a thorough estate plan. Here, the patient gives someone else the authority to sign contracts, sell investments, and otherwise take financial actions on behalf of the principal. Generally, a power of attorney remains in effect until the principal revokes it, becomes mentally incompetent, or dies. A designated “durable” power of attorney, however, remains effective even if the principal becomes mentally incompetent. A “springing” power of attorney becomes effective only upon certain events, such as the principal becoming incompetent (as certified by a physician) or otherwise unable to make financial decisions.
Checklist for Terminal Illness Planning
[ ] Tap health savings accounts (HSAs) to pay unreimbursed medical costs from tax-free funds.
[ ] Maximize itemized deductions for unreimbursed medical expenses. Keep receipts, including those for necessary travel.
[ ] Remember that modifications to a home in order to accommodate a disability are tax-deductible. Keep records showing that any such improvements are medically necessary.
[ ] Check on eligibility for disability insurance benefits—group, individual policies, or Social Security. Explain that any Social Security disability ben efits are taxable to the same extent as Social Security retiree benefits.
[ ] Notify individuals paying for caretakers whether they will be able to use the child and dependent care tax credits.
There is also the medical power of attorney, also known as a healthcare proxy, which allows someone to make medical decisions on the patient’s behalf. Planning for a terminally ill person should include determining whether such documents are already in place or creating them if necessary. If the patient is capable of making decisions about such documents, there should also be a living will, which describes the specific medical treatment desired when the individual is near death or incapacitated. Advisors should check state law for the legal status of these documents and also determine how vital decisions will be made in their absence.
