19 July 2012 0 Comments

Tax Considerations When Replacing Life Insurance And Annuities

Having discussed the replacement of one Permanent life insurance policy with another, it’s important to be aware of tax planning in this transaction. Enter Section 1035 of the Internal Revenue Code.

IRC 1035 allows for the tax free exchange of one policy for another and also carries forward the cost basis from the original policy. Here’s how it works. Assume you have paid $50,000 of total premium into your current life insurance policy and the current cash surrender value is $60,000. You have decided to discontinue your current policy and move the $60,000 to a new policy. If you merely surrender that policy for its cash value with the idea that you’ll send it on to the new insurance company, you must report the $10,000 gain as ordinary income. If your agent has you complete the appropriate paper work and the $60,000 is transferred directly from the old insurance company to the new one, there is no current taxable income.

Now, assume that instead of $60,000 of cash value your current policy has only $40,000. So, if you surrender it there is no taxable event. But, you will still want to process this replacement through 1035 procedures in order to carry forward the $50,000 cost basis in case you ever surrender the new policy.

If you have borrowed from your policy’s cash value, the amount of the loan is added to the net cash you receive in calculating whether or not tax is due. If the new policy for which you are applying does not carry a loan equal to the loan on your current policy, then there could be reportable income—even using 1035—equal to the lesser of the gain in the policy, or the amount of the loan. There is a way to avoid this by obtaining a new policy with a loan with wash interest. That’s too complicated to cover here. Just make sure your agent knows what he’s doing.

Section 1035 can be applied when replacing a life insurance policy with another life policy or with an annuity. It may also be applied when replacing an annuity with another annuity, but not if you are replacing an annuity with a life insurance policy. The insured person must be the same on the new policy as on the current policy, and that brings us to my next blog.

Next, second-to-die policies and replacement.

Leave a Reply