It’s Tax Time. You Might Want to Read This

This is the time of year I get calls from accountants about taxation on life insurance policies their clients surrendered or policies which lapsed during the preceding year.

Last week an accountant called on a client who surrendered two policies, one at a gain and one at a loss.  The obvious question is “Can the gain and loss off set each other?”  The answer is, generally, no.

This will not be a detailed discussion on this matter as I do not have the knowledge or authority for anyone to act on my comments, but, as with all things tax, it’s hard to find a definite answer of yes or no; just, generally, no.  In general, any “loss” on a surrender of a policy is considered the cost of past insurance protection.  Also, to take a loss, a transaction generally needs to be entered in to for profit, a topic on which courts have disagreed in the past.  There is an on going discussion of the ability to deduct a portion of the loss if the insurance and investment aspects of the transaction can be segregated and it can be proven the amount received is less than the difference between the premiums paid and the cost of protection.

But… in general, surrendering a life insurance policy for less than basis in not deductible.

However, the fun doesn’t stop there.  1099 surprises are where we get most of our calls.  Yesterday an account called us on a case where a business owner, when faced with a cash crunch, borrowed $100,000 from his policy which he actually paid back a few months later.  Believing he understood how things worked, and recalling that this was marketed at the point of sale as one of the multitude of benefits of the contract, he was understandably surprised and perturbed to receive a 1099 for the entire amount, none-the-less.

The problem?  The policy is a MEC, a modified endowment contract, which basically messes up some of the fundamental tax benefits of a life insurance policy.  I not getting under the hood on why this particular transaction was a MEC, if it started out that way, was somehow turned into a MEC and why the policy owner didn’t know.  One big frustration; the carrier simply sent the money without telling the policy owner it would be or could be taxable.  I can’t speak for other carriers’ policies, but it seems to be an invitation for trouble to not give the policy owner a head’s up.  Just saying…

Here’s the funnest part of all… when your client takes action on something without asking you because he or she doesn’t want to pay your fees or doesn’t want to hear what you have to say, they can too often regret it.

As I preach incessantly, many policies are underperforming, or as Charley Ratner is fond of saying, “They’re not underperforming, they’re under described”.  I agree but I will stick with the fact that they are underperforming projections and expectations.  They often follow one of two routes.  If they are universal life or variable universal life, the consistently declining interest crediting rates simply can’t drive the cash value to keep up with insurance costs and the policy drives itself into the ground.  This is like trying to maintain a standard of living in retirement based on projections of your 401(k) growing at 10% return over your working life when it only grew at 6%.  It ain’t gonna happen.  The policy will suffer and if not remediated, may simply fail and be thrown away.  Usually there will not be a gain when this happens unless there were outstanding loans in excess of basis.

With whole life policies, the almost constantly declining dividend rates over the past two to three decades has the same effect but can be, in some circumstances, even more insidious.  Many whole life policies were bought and sold as “short pays”.  Based on applicable dividend rates at the time of issue, projections were illustrated regarding how many premiums were to be paid out of pocket.   When dividends went down, and they all have, more premiums needed to be paid but few policy owners understood this.  The industry was using terms like “paid up policies” when, in fact, these were not paid up policies at all.  They are meaningfully different than true paid up policies.

Most whole life policies need premiums paid every year.  The question is, where are they coming from; out of pocket or from policy values or internal policy loans?  A bulk of these contracts I see come across my desk have dividends buying additional insurance and premiums, which are not being paid out of pocket, being paid from automatic internal policy loans.  What does this mean?

Whoo Boy!  When the dividends on a whole life policy go from 11% to 8% to 6% over time, that original 10 pay ledger, for example, doesn’t have a prayer of panning out close to expectations.  Premiums due from year 11 on were, from the beginning,  going to be loans but the policy at the higher projected dividends interest rates could service the loan and even continue to grow.  The loan would simply be paid off from death benefit proceeds.  At reduced dividend rates, with no additional infusion of funds, the accumulated policy loans and interest destroy the economics of the policy.  Picture the skeletonized arms of zombies reaching out of crypts grasping at the living and pulling them under.  This is unmanaged loans and life insurance.

Einstein is credited with stating some form of “the most powerful force in the universe is compound interest”.  We all know how it works over time to build assets.  Guess what!  It works just as well compounding debt… in life insurance policies.  More often than I could imagine, I am presented with a whole life policy, a “conservative” whole life policy from the highest rated, biggest named, most respected carriers on the planet, where the gain is measured in six, seven or eight figures due to loans.  With too many of these policies, the momentum of the loans is unstoppable and the policies collapse on themselves.

Oh well, I got screwed.  I’ll put it behind me, thinks the policy owner.  Then January rolls around and an envelope from the insurance carrier shows up.  Huh, I wonder what this is… open it up, look at it…

Ensuing conversation:

Policy Owner: What the… who the… how the… son of a —–!!!  Hey, Mr. Accountant. What the —- is going on here?  How do we fix this obvious insurance company mistake?

Accountant: Ummm, let’s call Bill.  Hey Bill, what’s up with this?

Bill: Hey dude, your client is screwed.  You’re an accountant, you know how forgiveness of debt is taxed.

Accountant: Yeah, but…

Bill: No buts

Accountant:  Really?

Bill: Really!

Accountant: You want to have a conference call with my client?

Bill: Sure, anything for you.

Bill & Accountant:  Hey Mr. Client.  You sitting down?

These are the “funnest” tax season discussions I have.  And I’ve seen some doozies.  I’ve seen cases where the tax liability on the phantom gain is greater than the entire expected death benefit.  I had a case where the tax liability on phantom gain was greater that the policy owner’s entire net worth, including his home.  It doesn’t get any scarier than this.

With a traditional investment, generally speaking, the most you could lose is what you have into it.  With life insurance, who knew you could lose everything you ever put in and be in hock to the IRS up to your eyeballs?

I’m not criticizing or bloviating… just saying.


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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