Recent Ruling Underscores Old Issue

In my never ending attempt to convince people of facts regarding life insurance products and management, I do not hesitate to pull in firepower from those more recognized and influential than me. Recently I received an update from Leimberg Information Services which opened with the following quote from Howard Zaritsky, lead author of Zaritsky and Leimberg – Tax Planning with Life Insurance: Analysis and Forms 2nd Edition, (800 950 1216):

“This issue keeps coming before the courts; there are numerous cases in which the insured has surrendered or cancelled an insurance policy or it has been terminated by the insurer, and the difference between the insured’s investment in the contract and the amount of the discharged loans has been realized as income.

This problem does not go away because so many policy owners simply do not read or understand the notices that insurers send them regarding policy loans. Typically, there will be at least several notices before a policy is terminated. An owner who does not receive cash on the policy termination will usually assume that there cannot be income. In fact, they have received the cash on which the tax is being imposed in the form of policy loans which now never will be repaid. The taxable income merely reflects the ‘day of reckoning’ that ultimately must occur, unless the loans are repaid.

There is little that estate planners can do with clients such as these. The law is clear and the surprise that awaits the policy owner when they get Form 1099-R saying that they have a substantial amount of income is merely an unfortunate fact of life for people who do not pay close attention to the communications they receive from their insurers.”

I have been saying this for years and years and it is not even a remotely controversial aspect of insurance and tax law yet it remains amazingly misunderstood. In fact, the specific details of the case at hand are remarkably similar to a real life case of mine a handful of years back. The year it was put in force, the amount put into it, the purpose of the policy and the year it fell apart are all within a year or two and a few thousand dollars of my client’s situation. The only meaningful difference is that my client’s gross distribution and taxable income was greater. For their $80,000 contribution they realized a $441,000 gross distribution with a $361,000 taxable gain.

The aspect of my client’s situation which is so spectacular is that they are middle class individuals who ended up in a tax nightmare where the tax they owed to the IRS alone exceeded their entire worldly net worth inclusive of the equity in their home. Most people could not fathom such a situation is theoretically possible let alone could happen in reality and I can sense that often the individuals with whom I am sharing the story secretly don’t even believe me, thinking that I am exaggerating in order to scare people into action. Actually, I am specifically trying to scare people into action but I wouldn’t exaggerate. It turns out that the plain truth can be pretty unsettling.

The AALU also just published a good summary of this particular case. I want to focus on a couple of paragraphs from it.

“Agents routinely tout the benefits of permanent life insurance policies to their clients. For a non-MEC life contract, withdrawals or partial surrenders up to cost basis are income tax free and loans are not treated as taxable distributions at all, according to longstanding and appropriate tax principles, unless the contract is surrendered or it lapses, subject to the loan. Unfortunately, upon lapse, an existing loan balance is treated as a potentially income taxable distribution from the contract.

Clients do not always understand the practical consequences of taking loans against their life insurance contracts. Policy debt and associated loan interest can add strain to a contract’s performance, putting the client’s expectations at risk and creating a potential tax time bomb if the policy is surrendered or is allowed to lapse when the loan is outstanding.”

With a few exceptions, I am generally agnostic when it comes to carrier, product type and strategy but I am fervently devout when it comes to making sure my clients and their advisors clearly know what they are getting in to. At times I have squashed premium financing cases, SERP plans and others, not because they might not work in theory (though some have little reasonable chance of success) but because I have zero confidence in the client being able to manage the program effectively and staying out of hot water down the road.

I have often stated that sometimes more can be communicated by what is not said than by what is said. When I see an agent focusing on the upsides of a deal and glossing over or entirely ignoring the downsides, I come in to be the counterpoint. When I see them leading the client to believe his premium dollars will actually be credited with the dividend rate or market return, I have to come to the table and make sure they understand the real deal. Yes, that makes me sound inherently negative but it’s my job at that point.

Life insurance is so powerful in and of itself, without the bells and whistles, I simply don’t understand why is has to so often be dressed up or mispostured.

Reproduced Courtesy Leimberg Information Services, Inc. (LISI).
Reprinted by Permission of the AALU.

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