It should be no secret that there are many landmines contained in older life insurance policies. But they are more often overlooked than looked over. Many life insurance policies that the buyers assumed were “permanent” (i.e., would last until the insured dies) are unlikely to endure as long as their long-lived insureds. Old policies that are most at risk were sold at a time of higher interest rates with rosy projections of future performance and funded with the lowest premium possible.

For some policies, the loss of the expected insurance benefits is not the biggest hurt. Adding to the pain could be a very large, unanticipated tax bill. These come with collapsed policies that had very large loans against them.

With whole life policies, the non-payment of premiums results in an “automatic premium loan.” Unpaid premiums over many years run up large loans with accumulated interest. Without premiums and/or interest being paid, the loan can grow to exceed the policy cash value and death benefit. When that happens and the policy falls apart, the entire loan and interest, less the past premium outlay, is taxable ordinary income, which can mean an unanticipated tax bill in the hundreds of thousands of dollars.

We currently have two clients with this potential situation. There is no painless way out. The challenge is to find the least costly future course in order to avoid the worst of both worlds – no insurance and a very large tax liability. Policy owners and advisors, beware.