Capturing Loss in a Life Policy

A Happy and Prosperous 2013 to Everyone!

I’ll start out the year with a short and simple post. Sometimes it’s the simple, not so glamorous ideas that can be powerful but easily forgotten.

The nature of much of my work is that too often I have to give policy owners the bad news that their policy is failing or that remediation strategies are not reasonable. Sometimes they choose to bail on their policies because a 1035 exchange doesn’t fit their objectives or a life settlement isn’t in the cards. Many of these contracts have a cash surrender value substantively less than basis in the contract but the “loss” is usually not deductible nor can it offset gain in another transaction. In that case the loss is lost.

There is a very simple strategy which allows this loss to be captured when the dynamics of the situation warrant it and this was covered in a recent Wall Street Journal article. Here is a simplistic summary of the details.

In a 1035 exchange, the basis of the “old” contract is carried over as the basis of the new contract. Furthermore, while an annuity may not be exchanged under the 1035 guidelines to a life insurance policy, a life insurance policy may generally be exchanged to an annuity subject to guidelines. This means that, for example, if a life policy with a $100,000 basis and a cash value of $50,000 is exchanged into an annuity, the $50,000 annuity has a $100,000 basis. The result is that the annuity could then double in value with no gain. Even if there isn’t a burning desire to own an annuity, the tax advantages of doing so may be worth considering it.

I’ve seen policies with $1,000,000 in basis on the cusp of collapse with minimal cash value, let’s say, $10,000. The strategy wouldn’t seem so useful seeing that the $10,000 would never grow enough to take advantage of all the available sheltered gain. But what if $500,000 was added to the annuity after the exchange, assuming the annuity could accept additional funds? Now you would have a $510,000 annuity with a $1,500,000 basis which could triple in value with no tax. If the policy owner’s tax counsel agrees, this could be meaningful. Whether a fixed deferred or immediate annuity is appropriate or a variable annuity with more upside potential to take advantage of the strategy is utilized, there will clearly be scenarios where this could be invaluable.

In other words, this isn’t something you want to remember or be reminded of after the policy was surrendered when it could have benefited your client!


This material is for informational purposes only and should not be considered tax or legal advice. Any person needing tax or legal assistance should contact their respective advisors.

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