27 July 2012 0 Comments

Tax Leverage From Life Insurance That Is No Longer Needed

I’ve covered just about every situation pertaining to the replacement of life insurance, including the importance of IRC Section 1035, for tax free exchanges. But, before moving on, there is one remaining scenario that deserves attention. Remember, I warned that Section 1035 does not apply if you want to replace an annuity with a life insurance policy, but going from a life insurance policy to an annuity does work. Here’s how that could be important:

Take the case of the 70 year old male who owns a life insurance policy that is no longer needed. His dependents are gone and his major concern now is to maximize income. His life insurance policy has a current cash value of $80,000 and a cost basis of $100,000 (total premiums paid).

He plans to cash in the life insurance and use the $80,000 to purchase an Immediate Annuity that will guarantee him a lifetime monthly income of $524.20. Part of each payment will be tax free because it is considered to be a return of basis. No income tax is due when he surrenders the life insurance because his basis ($100,000) is greater than the amount he receives. But, instead of surrendering the policy he transfers its $80,000 cash via a Section 1035 exchange directly to the company issuing the annuity. This doesn’t affect the amount of income he receives, but since the 1035 exchange has carried the $100,000 cost basis forward, the amount excluded from income is increased from $416.74 per month to the full $524.20 per month until basis is recovered. That’s a huge advantage just for knowing how to do it the right way.

If the cost basis of the life insurance policy is less than its cash surrender value, a 1035 exchange will avoid current taxation on that gain, but will result in a larger portion of the annuity payment being subject to taxation. Still, avoiding a current lump sum tax is probably smarter than spreading a slightly higher taxation over a number of years.

If a Deferred Annuity is being considered instead of an Immediate Annuity, the same principals apply with regard to using a 1035 exchange instead of surrendering the life insurance.

But hold on! I’ve just launched into the whole subject of Annuities without so much as a hint of defining what an Annuity is. So, that’s what we tackle next.

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