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Happy 100th birthday! Here's why you could end up with surprise taxes

CNBC logo CNBC 11/4/2018
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Uncle Sam has a birthday gift for certain people who make it to 100: A tax bill.

This applies to those who purchased so-called permanent life insurance to address complex financial planning needs, including estate planning. These contracts come with a savings component, known as cash value, which accumulates free of taxes.

Your heirs generally get a death benefit payout free of income taxes if you pass away. But if you beat the insurance company by surviving to see 100, your insurer could cash you out of your policy, potentially leading to taxes.

"You've turned an income-tax free death benefit into a tax-bill, and most likely it will pay less than the death benefit, too," said Tom Love, vice president of insurance analytics at Valmark Financial Group.

Here's why your centenary might be a little less sweet.

Mortality tables

Insurance companies price their policies based on mortality tables, which measure the likelihood of a person of a certain age dying in a given year.

Though permanent life insurance is intended to remain in force for as long as you're alive and paying premiums — unlike term policies which typically last 20 or 30 years — these contracts have a maturity date that historically has kicked in on a policyholder's 100th birthday.

On that date, your insurance company will pay you the cash value and end your contract.

This amount could be less than the death benefits your heirs would have received.

You will be taxed on the cash value to the extent these proceeds exceed the amount of premiums you've paid.

In the worst of scenarios, if you have a large loan against your policy at age 100, your debt will be forgiven, but you'll still be on the hook for taxes for the cash value and the amount borrowed.

"The best 'bad' result is that you pay the tax, but at least you have cash in the policy," said Barry D. Flagg, a certified financial planner and founder of Veralytic, a publisher of life insurance pricing and research.

"Worst result is that you have no cash, but you still owe the tax," said Flagg. "In both cases, you lose your life insurance."

The problem with 100

Many permanent life insurance policies issued prior to 2004 have a maturity date of 100, according to Michael Lovendusky, vice president and associate general counsel of the American Council of Life Insurers.

Over time, the number of centenarians has swelled.

"At the time when these tables were established, it was something that the industry didn't think about," said Love.

"The odds of people living to 100 were insignificant from an actuarial perspective," he said.

Globally, there were close to half a million individuals over age 100 in 2015, according to the Pew Research Center. That number is expected to grow to nearly 3.7 million by 2050.

In the U.S. alone, there were 72,197 Americans aged 100 and over in 2014, the U.S. Centers for Disease Control and Prevention found.

To contend with the growing number of centenarians, in 2004 state insurance commissioners adopted an updated mortality table that has pushed out the maturity date of new policies to age 121.

This means you can keep your coverage intact well beyond your 100th birthday if you have one of these newer policies.

Tax outcomes

Don't wait until the day before your 100th birthday to find out if a surprise tax is around the corner. Instead, talk to your advisor about the following potential options.

Ask about a maturity extension rider: Some policies have a feature that allow you to push out the maturity date of your policy without trading in your contract, but you may not know unless you ask your insurer.

You may need to swap contracts: If there's no maturity extension feature on your old insurance policy and you need coverage, talk to your advisor about whether it makes sense to switch to a new contract with a maturity date of 121.

Time is of the essence. "Thinking about it in your 70s isn't too early," said Flagg. "Over age 80, they're less likely to give you preferred rates."

Related video: Here are the best flex jobs for retirees

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