Why We Keep Term Life Insurance After Financial Independence
We are living on our savings—money earned from our corporate careers and the sale of our home—so, we are intentional about what we spend.
One area where we have considered cutting back finances term life insurance. We purchased policies in our late 20s and have maintained them since then. Most people establish life insurance when they have a spouse and/or children dependent on their income such that if they die, those dependent on their income will be provided for. Since we are now financially independent and no longer needed to replace one or the other’s W2 wages if one of us passes, we were wondering if we should continue to pay for term life insurance. As child-free early retirees, we also don’t have dependents that we need to consider in deciding to maintain or drop our life insurance policies.
We’d also heard several financial independence vloggers and podcasters talk about cancelling their term life insurance after early retirement, to save a few hundred dollars per year on their life insurance premiums for the next 15 - 20 years. However, we hesitate to join them in eliminating this expense for ourselves. In this blog, we discuss less common reasons to maintain a life insurance policy as well as the potential financial impacts of not having life insurance down the road. One of those potential impacts is what called the “widow tax.”
Who Are We?
Darren and I are early retirees who left corporate careers in our late 40s. We are nomadic except for three months a year, when we spend time in our tiny home in the Great Plains of the United States. We spend 40 - 120 days per year through-hiking in the EU and about 90 days per year in the Caribbean and Central America. This blog documents our journey to and in nomadic living and financial independence.
What is Term Life Insurance?
Unlike a whole life policy, a term policy expires after a set number of years when the policyholder outlives the specified term. Alternatively, if the policyholder passes away before the term expires, and the policyholder is not delinquent on policy payments, the policy will pay out the specified benefit based upon the plan.
Term life insurance can be purchased in increments of 5 years, typically 5, 10, 15, 20, 25, and 30-year policies. These policies are typically less expensive than whole life policies as they have no cash value after the agreed term runs out. Check out this article to learn more about Term Life Insurance, including the best companies from which to purchase term life insurance.
What is the Purpose of Term Life Insurance?
Term life insurance policies are intended to provide financial security for an individual or family in case the policyholder dies. The purpose of term life insurance is to provide coverage for a specified (term) number of years.
Our Term Life Insurance and Cost
When we were in our early 30s, we purchased two term life insurance policies, one for myself and one for my husband. We purchased 30-year term life insurance plans, each for $500,000. The premium cost of our two plans combined is $68.69 per month. These term plans will expire when we are in our early 60s.
We purchased 30 year plans as we anticipated working 30 more years from the time of purchase. At that time we didn’t know if we wanted to have children and were not yet familiar with the concept of FIRE. We both had modest incomes at the time and wanted to make sure that a surviving spouse could pay the mortgage on our small Indiana home and cover any other financial needs that might arise. Additionally, we liked that the premiums would not increase during the duration of the policy.
There is no penalty for early cancellation for our policy. So when we left the workforce, we considered dropping it and investing the premium in a low cost index fund. However, after more thought and research we found some reasons why we may want to keep the policy in place.
Why Some Early-Retired Couples May Want Term Life Insurance: The Widow’s Tax
If you’ve been investing for 20 years or more in a 401k or 403b, you may not be aware of the potential tax burden that grows with your account balance.
If you are an early retiree doing Roth conversions or a traditional retiree making withdrawals from tax deferred accounts, you pay taxes on these distributions at regular income tax rates.
If one spouse passes away young and the remaining spouse does not remarry and has no dependents, the living spouse will pay taxes on both individual’s tax deferred accounts if they perform Roth conversions or take a distribution.
We ran through the scenario below to understand what additional tax burden might be on a surviving spouse.
15 Years of Roth Conversions Scenario
A dual-income couple each puts $15,000 in their own tax-deferred accounts (typically a 401k or 403b, assuming no employer match). They invest in low-cost index funds inside these accounts for 20 years—let’s say from age 30 to age 50. Assuming a 7% interest rate, their 401k balance will be close to $1,000,000 each by age 50.
Now, let’s say this couple both leave traditional employment at age 50. Knowing that their income will be quite low until age 65, they may pursue some part time self-employment or seasonal work.
By reading The New Retirement Savings Time Bomb by Ed Slott, this couple knows that if that money just sits in the 401k for 15 years (until age 65) that amount may grow to $3,000,000 for each person with no further investments. They also know that if they delay distributions until age 65, distributions from this account will likely place them in the highest tax bracket of their lives (37% or higher), and increase their Medicare premiums.
Instead of waiting for the tax bomb to explode at age 65, this couple decides to use the next 15 years of early retirement (age 50 to 65) to prepay the tax on the tax deferred moneys and move it into their Roth accounts. There in the Roth accounts, the stocks grow and are not taxed upon withdrawal after age 59.5, thereby reducing their future tax liabilities by over $500,000 in a lifetime.
This is all well and good, except … what if one of the spouses passes early in early retirement?
How Much Do Roth Conversions Cost for Married Couples vs Single People?
In 2022, if you had no income but did $200,000 of Roth conversions as a married couple filing jointly, your federal tax amount would be $29,536. If you are filing as single, your federal tax amount would be $36,525. In a nutshell, each year a single person does a Roth conversion of $200k, they pay almost $7000 more in income taxes than a married couple.
If you are located in a state with a marginal tax rate of 5.7%, your state tax would be $10,615 as a single person and $9773 for a married couple. In a nutshell, every year a single person does a Roth conversion of $200k, they may pay $800+ more in state taxes than a married couple.
Other Reasons for Keeping Term Life Insurance in Early Retirement
In addition to the Roth Conversions scenario, there are a few other reasons we’ve opted to keep our term life insurance in early retirement.
Offset Lost Opportunity Cost of HSA Family Contributions
By contributing to an HSA, people are able to invest pre-tax funds and realize gains tax-free. HSA’s are not directly connected to life insurance but contribution limits for an individual are half of what they are for a couple. In 2022, these limits are $7300 for a couple and $3650 for an individual. Therefore, following the death of a spouse, the surviving spouse may now only contribute half of what the couple had previously been able to invest and likely subsequently realize only half of the financial gain from those investments. In other words, if a married couple has been contributing to an HSA and one spouse passes, that individual loses out on half of the eligible HSA tax benefits that they may have gotten as a married couple.
As an example, if a spouse passes at age 51 in 2022, the surviving spouse can contribute $3650 instead of $7200 (based on 2022 limits). The HSA widow tax for this person could be $54,750 (contributions) and $53,462 growth, assuming the HSA contributions stay the same and that investments grow 7% over 15 years. With these assumptions, a widowed individual could lose out on $108,212 of contributions and investment growth.
Reduction of Social Security Income
When both spouses are collecting Social Security and one passes, the surviving spouse generally receives whichever is greater: their own benefit or their deceased spouse’s benefit. If both spouses are anticipated to receive $2,000 for a combined monthly total of $4,000, the remaining spouse will now receive $2,000, which is a loss of income of $2,000 per month.
Assuming that one spouse passes before age 62, if the remaining spouse lives to age 87 and planned to start receiving Social Security benefits at age 67, the loss of benefits for the remaining spouse is $480,000 over their remaining lifetime.
Replacement of Pension Income
The number of Americans eligible for a pension is declining. However there are some individuals, even some GenXers like ourselves, who will likely receive a pension. Not all of these pensions have survivor benefits.
If one partner is eligible for a pension and that pension does not have survival benefits, a monthly pension of $2000 could be reduced to $0 for the remaining spouse. If the second spouse were to live another 20 years this would result in a loss of income for the remaining spouse for $480,000 over those 20 years. If the $2000 pension allows for 50% of benefits to be relayed to the remaining spouse, the loss of income could be $240,000 over their remaining lifetime of 20 years.
If a spouse passes before a term life insurance period ends, the policy can offset some of the lost income from Social Security and Pension income loss for the surviving spouse.
Reduction of Capital Gains Exemption
The capital gains exemption on a primary residence is currently $500,000 for a married couple and $250,000 for a single person. Therefore, consider a scenario where a couple bought a house for $100,000 and it appreciates to $600,000. A couple would pay no capital gains on the house, but a single person would pay capital gains on $250,000, which in 2022 would be $37,500. A term life insurance settlement would help the surviving spouse offset this added tax burden.
Term Life Insurance as Reimbursement for Early Long Term Care
For those who have saved and invested for 20 years as a dual income couple or 40 years as a single income household, they may have accumulated enough of a nest egg to self-insure long term care instead of purchasing expensive long term care insurance products. The White Coat Investor recently wrote an article on this topic, projecting that long term care may cost between $300,000 to $600,000.
Since many aging people receive some care from their children as they age, child-free couples don’t have children to depend upon and therefore may incur higher long-term care costs during their lives. In our case, if one of us was to need long-term care before the age of 62, and passes during the time we are covered by our term life insurance premiums, the surviving spouse would likely be reimbursed by a less expensive term life plan than an expensive long term care plan.
Conclusion: The Decision to Cancel or Keep Term Life Insurance as Early Retirees
We considered cancelling our term life insurance last year, thinking about how we might spend a few hundred dollars per year with the premium savings.
However, we decided to keep our term life insurance after thinking through the following scenarios:
“Widow Tax” - moving from the married filing jointly status to single status
HSA “Widow Tax”
Reimbursing a surviving spouse’s out-of-pocket early long term care costs if one spouse needs long term care for a period of up to 5 years before passing during the coverage period.
We will consider cancelling our term life insurance again in 2026 when the tax code is set to change. We’ll also have had a few more years of Roth Conversions under our belts, so we will run the numbers again at that time.
In the meantime, we accept the “cons” of term life plans:
Re-qualification -we don’t plan to do this
Premium increase when you take out a new term - we don’t plan to do this, either
Policy accumulates no cash value - we accept the costs as items in our annual budget
If we keep paying about $825 per year for our term life insurance until age 62 (12 more years), we can rest well at night knowing that if one of us passes, the remaining spouse has $500,000 to do the following:
Replace lost Social Security Income
Replace lost pension income
Replace long-term care expenses that may have been incurred
Fund added federal and state income taxes to complete Roth conversions at the more expensive single tax bracket
Replace lost HSA contributions and growth
Help pay capital gains taxes
What are your thoughts on and experiences with term life insurance? Please share in the comments!
