Last month I wrote about the possibilities of salvaging basis on underwater life insurance contracts by utilizing annuities. The discussion included two different aspects of potential planning opportunities.
The first is the common practice of doing a 1035 exchange from a life insurance contract to an annuity. For policies in a gain position, this allows the gain to be deferred. For policies in a loss position, this may allow the salvage of the basis rather than wasting it. The remaining cash value exchanged into an annuity may appreciate tax free.
I briefly touched on a more aggressive opportunity wherein someone may conceivably do an exchange from an underwater life insurance policy into an annuity and subsequently surrender the annuity and take the loss. Again, this is more aggressive and there will be differences of opinion but the discussion is worthwhile.
Coincidentally, very shortly after my post, Steve Leimberg’s Income Tax Planning Newsletter (Archive Message #101) featured writing from Michael Geeraerts which focused deeply on the possibility of deductibility loss by surrendering an annuity after a 1035 exchange of an underwater life insurance policy. Here is the intro:
Steve Leimberg’s Income Tax Planning Email Newsletter – Archive Message #101
From: Steve Leimberg’s Income Tax Planning Newsletter
Subject: Michael Geeraerts: Underwater Life Insurance Policy About to Drown: Can a 1035 Exchange Into an Annuity Followed by Surrender Help Float a Deductible Loss?
Indexed Universal Life Insurance (IUL), Variable Life Insurance (VL) and Private Placement Life Insurance (PPLI) certainly have their place and use. Unfortunately, many clients purchased these products anticipating great returns. However, the markets are not always kind and as we have seen since the 2008 Great Recession, many investments, including those underlying IUL, VL, and PPLI, have suffered severe losses. This has led to many underwater permanent life insurance policies being on the verge of imploding and clients receiving little to no return on their premiums.
Clients often do not want to put more money into these policies and just want to cut their losses. This leads sophisticated clients and their advisors to try creative strategies to reduce the loss and pain from these policies which will lapse soon without additional premiums being paid into them. One strategy that has been gaining some traction lately in the advisor community involves completing a 1035 exchange from an underwater life insurance policy into an annuity followed by surrendering the annuity at a loss and claiming a tax deduction for the loss realized on the annuity surrender.
I encourage everyone to read the full analysis as it does a great job of digging deep into the issue, providing warnings as well as suggestions and advice.
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.