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Articles | Exchanging Cash Value Insurance Policies Can Lead to Future Tax Savings
Exchanging Cash Value Insurance Policies Can Lead to Future Tax Savings
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
- "Term" life insurance which pays out a fixed death benefit and does not have
an investment component; and
- "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
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
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:
- 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;
- An annuity owner may be able to move money in an annuity to a better
- 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:
- Determine if a "1035 exchange" makes sense:
- Guide the insured or annuity owner through the process; and
- 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
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.
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.