Many property and casualty agencies have particular insureds who might benefit from a tax-free exchange of cash value life insurance into immediate or fixed deferred annuities.
The U.S. population presently has approximately 78 million people, born between 1946 and 1964, who classify as being “baby boomers.” Some of these baby boomers have whole life (cash value) and universal life policies that they purchased when their insurance needs were different. As life expectancies increase, however, these baby boomers now worry more about outliving their assets than on having their cash value policies pay a death benefit to their beneficiaries or estate after they have passed.
For those baby boomers with cash value whole life or universal life policies, a tax-free exchange to an immediate or fixed deferred annuity using § 1035 of the Internal Revenue Code may alleviate some of their concerns about outliving their assets.
Why recommend just immediate and fixed deferred annuities and not variable or equity indexed annuities
Immediate annuities and fixed deferred annuities (involving insureds over age 59½) offer both the selling agent and the insured they are advising simplicity and transparency. These annuities have relatively few variables to juggle relating to their payout terms, annuity charges, surrender charges and the annuity company’s financial stability.
The more complicated annuity products, such as variable and indexed annuities, require extensive knowledge of differing contract terms and conditions to determine their suitability for potential purchasers. Additionally, their sale may require special licensing if the annuity qualifies as a security. The sale of immediate annuities and fixed deferred annuities, however, only requires a property and casualty insurance agency to have the appropriate insurance license.
Also, from a marketing point of view, the sale of these plain vanilla immediate and fixed deferred annuities has surged in the last two years even though interest rates are at an all-time low. Much of this increase in sales has been ascribed to § 1035 exchanges arising out of the concerns of baby boomers regarding retirement funding.
Section 1035 applies to more than annuity exchanges
Many agents know that § 1035 allows for the cash value of one life insurance policy, such as a whole life insurance policy, to be transferred to a different life insurance policy, such as a variable life insurance policy.[pullquote] § 1035 offers a much broader vehicle for tax-free exchanges than the common life insurance policy-to-life insurance policy exchange[/pullquote]
Actually though, § 1035 offers a much broader vehicle for tax-free exchanges than the common life insurance policy-to-life insurance policy exchange. The categories of such exchanges as set forth in Title 26 U. S. Code § 1035 allows a tax-free exchange of:
(1) a contract of life insurance for another contract of life insurance or for an endowment or annuity contract or for a qualified long-term care insurance contract; or
(2) a contract of endowment insurance (A) for another contract of endowment insurance which provides for regular payments beginning at a date not later than the date payments would have begun under the contract exchanged, or (B) for an annuity contract, or (C) for a qualified long-term care insurance contract;
(3) an annuity contract for an annuity contract or for a qualified long-term care insurance contract; or
(4) a qualified long-term care insurance contract for a qualified long-term care insurance contract.
If done properly, § 1035 provides that “No gain or loss shall be recognized on the allowed exchanges of these life contracts and annuities to either other life contracts, annuities or long-term care insurance contracts. In other words, the conversion of a whole life or universal life’s cash value into an immediate or fixed deferred annuity, or other qualified contract, continues an insured’s tax-deferred status.
An Actual Example of a Cash Value Life Insurance Policy that is going to be exchanged
An insured with a $270,000 cash value policy has asked if he would fare better by cashing in his policy and investing the proceeds in no load mutual funds or low cost exchange traded funds (EFTs).
This particular policy was purchased in the 1980s and requires a quarterly premium payment of $1,259.00. This quarterly premium has been paid timely for the 28 years the policy has been in force. The policy now has an accumulated cash value of $269,338.57 as of August 2014. A copy of the Benefits Summary shows these numbers:
The insured on this policy has no immediate plans to retire at age 67, when he qualifies for Social Security but he does have real concerns about him and his wife outliving their retirement assets.
Why just surrendering a policy and investing the cash value is a bad idea
The surrender of the policy to put its $269,338.00 cash value into more efficient investments would result in the following federal income tax consequences. The cash value of $269,338.00 would have the total premium paid of $140,157 deducted for income tax purposes since the insured paid these premiums with after tax dollars. However, upon surrender of the policy the remaining $129,180.00 of the policy’s cash value that accumulated tax free now becomes taxable as ordinary income. Since this person pays $43,060.00 based on this person’s present 33% federal tax rate. The following table shows the taxes that would be due on surrender:
Surrender cash value of life policy $269,338.00
Premiums paid by insured $140,157.00
Ordinary income realized on policy surrender $129,180.00
Federal income tax due (33% bracket) $ 43,060.00
Of course, if this additional income bumped him up a tax bracket, he could actually pay $51,155 in income tax upon the surrender of the policy.
Can the cash value of this whole life policy be used more effectively by a tax-free exchange into an immediate or fixed deferred annuity?
With regard to the person who gave Agency Checklists the policy information for this article, the answer may well be, “Yes.”
This insured is married and would like to supplement his social security when he qualifies. A tax-free exchange of his existing whole life policy’s $270,000 cash value would purchase a joint annuity for the lives of both he and his wife. He would pay approximately $1700 per month. Of this monthly amount, the insured (now annuitant) would receive approximately $1000 tax free with the balance of the monthly check, $700, received asudable in his taxable income.
Also, as a result of this exchange, this insured also gains an additional $5,000 per year by no longer paying the annual premium for his whole life policy.
How many agents have alerted their baby boomer insureds about tax-free exchanges?
The insured in the example above has used the same property and casualty agency for over 30 years. He has received from this agency over those years information about the advantages of purchasing umbrella coverage, flood insurance, earthquake insurance, and other types of property and casualty insurance. But, he has never received anything that advises him on this issue:
As your trusted insurance advisor, I wanted to advise you that if you or any of your friends or business associates have cash-value life insurance and are considering retirement, you may want to check if a tax-free exchange of this policy’s cash value for an immediate or fixed deferred annuity would better serve your retirement goals.
Of course, the advice could offer more detail, but interested agents will get the idea.
- Baby boomers with cash value policies, approaching retirement or actually retired, are going to have or already have one of the best annuity deals in the world: Social Security. If they like Social Security’s monthly payments and are worried about outliving their assets, you should let them know about immediate or fixed deferred annuities to supplement their governmental annuity.
- There are a number of specialized life, annuity and long-term care products in the market that can offer extremely suitable investment vehicles for insureds looking to enhance their return through a § 1035 Exchange. However, a number of these more exotic financial products have risk and expense profiles that make them extremely unsuitable for general sales. They also will require security sale licenses if the annuity qualifies as a security. Unless your agency is correctly licensed, well-versed in these products and well-insured it is best to stick to selling the immediate and fixed deferred annuities. These products may have less pizazz than the latest hot product, but they offer greater predictability for your insured and less risk to your agency.
- Be careful on the transferred basis of any § 1035 exchange. In such exchanges, the cost basis of the original product carries over to the new product acquired in the tax-free exchange under § 1035. For what can happen when you get the basis wrong, see Agency Checklists’ article of August 27, 2013, MA State Treasurer Gets A $500,000 Tax Bill From A Life Policy Exchange That Went Awry.
- In Massachusetts, any § 1035 exchange involving the replacement of a life insurance or annuity product has to comply with the replacement regulations found at 211 CMR 34.00 (A copy of which can be accessed here): The Replacement of Life Insurance and Annuities.