Edward A. Zurndorfer, Certified Financial Planner

Unlike capital losses resulting from the sale of certain assets such as stocks or bonds, any losses resulting from the sale of a cash value life insurance policy cannot offset any gains resulting from the sale of other capital assets. But there is a simple but little known technique that allows a cash value life insurance policy owner to possibly save in taxes through a "1035 exchange".

This column discusses a "1035 exchange", named for the Internal Revenue Code Section that permits this "exchange".

Before discussing a "1035 exchange", it is important to review the different types of life insurance policies. There are two types of life insurance policies, namely:

1. "Term" life insurance which pays out a fixed death benefit and does not have an investment component; and
2. "Cash value" or permanent life insurance which combines a death benefit with a savings or investment account.

With a cash value life insurance policy, the insurance company collects a larger premium from the policyholder. The insurance company deducts the cost of the death benefit - the "pure" life insurance - and other insurance-related expenses and fees from the policy premiums and cash deposits.  Whatever remains from the premiums and cash deposits is put into an investment account for the benefit of the policy owner. Earnings grow at least tax-deferred in the investment account.

But like other types of investment accounts, an investment account in a cash value life insurance policy can lose money. For example, a previous MFR column discussed how many universal life (UL) policy owners who bought their UL policies at a time when interest rates were higher compared to today's low interest rates. These policy owners are noticing that their policies are worth much less compared to the total amount of premiums they have paid through the years.

Those cash value policy owners whose total cash value in their policies are worth much less compared to the premiums may be tempted to terminate their policies. But depending on how a cash value life insurance policy that has decreased in value is terminated can make a huge difference in the tax liability for the policy owner.

There may be other reasons besides a decrease in value for terminating a cash value life insurance policy. For example, an individual may no longer need life insurance because their children are grown and financially independent. Or a policy owner cannot afford the cash value life insurance premiums and decides to buy a cheaper term life insurance policy.

If a policy's surrender value -- the cash value of the policy less any surrender charges -- is less than the total premiums paid in and the policy is sold or terminated -- any resulting loss is nondeductible on one's income taxes. In other words, the resulting loss cannot be used to reduce one's other income or to offset the capital gains resulting from the sale of other capital assets including stocks, bonds and open-ended funds.

There is only one way that the realized losses in a cash value life insurance policy can be utilized. That way is through transferring the cash value to an annuity. This transaction is called a "1035 exchange" and it is most commonly used to transfer cash value from one annuity to another, from one cash life insurance policy to another cash value life insurance policy, and from a cash value life insurance policy to an annuity. Many insurance agents will frequently and unnecessarily suggest a life insurance to life insurance transfer, perhaps because of financial incentives.

Consider the following example: An individual has contributed $100,000 into a cash value life insurance policy over the past 20 years. The policy's surrender value of $70,000 is transferred via a "1035 exchange" to an annuity. As such, the annuity will then have a starting value of $70,000. But the annuity's "cost basis" -- the original cost of the investment used to determine the amount of capital gain or capital loss when the annuity is sold -- will be $100,000.  Put in another way, if the annuity owner will not owe taxes on the first $30,000 ($100,000 less $70,000, or the original investment less surrender values of the annuity's earnings), withdrawn from the policy.

Annuity owners can add extra money into their annuities which could allow the owners to take advantage of their losses faster as they accrue additional earnings which are subsequently withdrawn.

As stated earlier, "1035 exchanges" derive from Internal Revenue Code Section 1035. As such, the IRS sets the rules for these exchanges. The following are the requirements for a "1035 exchange".

• The cash value from a cash value life insurance policy can be transferred into: (1) Another cash value life insurance policy; (2) An endowment policy (whole life policy); or into (3) An annuity. Annuity funds can be transferred into another annuity policy or to an endowment policy. But an annuity cannot be transferred to a cash value life insurance policy such as a UL policy or a variable life insurance policy.
• A cash value life insurance policy owner or an annuity owner cannot sell one policy or annuity, receive the cash proceeds, and then invest the proceeds to buy another policy or annuity. The policy or annuity must be directly exchanged in a business-to-business transaction. In other words, if the policy owner or annuity owner takes hold of the cash value, then they will be taxed.
• The cash value life insurance policy owner must be the owner and the insured in the new cash value life insurance policy. The annuity owner must be the owner of the new annuity. The annuity owner and the endowment policy must be both the insured and the annuity owner.

Also, in order to take advantage of a "1035 exchange" a cash value life insurance policy must have a positive surrender value. Those policies that have no cash value -- perhaps a cash value life insurance policy that was purchased in the last three years and has either lost money or has not had time to build a positive surrender value -- cannot be exchanged.

There may other reasons besides possible tax savings for doing a "1035 exchange", particularly with respect to cash value life insurance policies. These reasons include:

1. The policy owner's health status has changed for the better. For example, the policy owner has stopped smoking and  can now qualify for a lower premium or higher death benefit with a new policy;
2. An annuity owner may be able to move money in an annuity to a better performing annuity;
3. A life insurance policy owner opts for a lower death benefit on the new life insurance policy thereby lowering premiums; and (4) A life insurance policy owner may be worried an existing carrier's financial strength and want a more secure policy with a different insurer.

This column has presented the basics of "1035 exchanges and how "1035 exchanges" can be of benefit to some cash value life insurance policy and annuity owners. For those employees who may be interested in a "1035 exchange" the process of dealing with an existing and a new insurance company via a "1035 exchange" can be outright complex and professional help is highly recommended. An independent life insurance agent or broker familiar with the cash value life insurance and annuity markets and "1035 exchanges" is therefore highly recommended. This individual will ideally:

1. Determine if a "1035 exchange" makes sense:
2. Guide the insured or annuity owner through the process; and
3. Makes sure the insured or annuity owner is familiar and understands the tax issues as well as the consequences of a new life insurance policy or an annuity.

Federal employees and retirees who may be interested in a "1035 exchange" are therefore encouraged to look for an independent and experienced life insurance agent or broker who will assist the employee or retiree in effecting a "1035 exchange" in the most efficient, least costly, and tax beneficial way.

Posted:  12/11/2012

About the Author

Edward A. Zurndorfer is a Certified Financial Planner, Chartered Financial Consultant, Chartered Life Underwriter, Registered Health Underwriter, Registered Employee Benefits Consultant and Enrolled Agent in Silver Spring, MD -- and the owner of EZ Accounting and Financial Services, an accounting, tax preparation and financial planning firm also located in Silver Spring, MD.  Zurndorfer is also is an instructor at federal employee retirement seminars throughout the country and writes numerous columns and books on federal employee benefits.