16 May 2014 0 Comments

What do you do with the cash?

shutterstock_134238566In my last entry I discussed steps to take when replacing one life insurance policy with another.  Now I’ll cover what considerations there are when a life insurance policy that has cash value is either being replaced or discontinued.

Options available to use the cash to continue insurance with the same policy were covered two entries ago when I discussed life insurance in ILIT’S.  Those options really only work if your goal is either to reduce the face amount or continue coverage for a limited period of time.  If the goal is to replace one permanent policy with another for the full amount—or more—then it is likely that you will transfer the cash value to a new policy using IRC Section 1035 to avoid any adverse tax consequences.  Why would you want to do this?  Either to increase the face amount, improve guarantees or decrease the premium—or a combination of these advantages.  Be sure that the current policy is not surrendered prior to delivery of the new policy and you are convinced that there is an advantage to proceed with the replacement.

If the new policy is on a different life—such as changing from a single life contract to a second-to-die policy—a Section 1035 transfer is not possible.  If surrendering the policy produces a taxable gain, you may want to avoid this immediate taxable event by transferring to an immediate annuity under Section 1035 and then use the income to pay for premiums on the new policy.  This doesn’t avoid taxes, but it spreads it out.

If the old policy’s cumulative premium exceeds its cash value and you do not want any more insurance, you can just cash it in with no taxes due.  On the other hand, if you plan to use this cash for retirement income, you might consider transferring the cash via Section 1035 into an annuity.  By following this procedure the cash basis of the discontinued life policy is transferred into the annuity producing lower taxation on subsequent payments received from the annuity.

If you cash in a policy with an existing policy loan there may be income tax due even if the net amount you receive is less than the cumulative premiums paid.   In calculating ordinary income tax on the gain, the gain will be the sum of the net cash received, plus the loan forgiven, less the cumulative premiums paid.  Even if cash is transferred from a policy with a loan to a new policy via Section 1035, unless the new policy has an exact same loan, there would be ordinary income tax due on an amount equal to the lesser of the gain in the policy or the amount of forgiveness of loan in the new policy.

Deal with an agent who understands cash value policies and move with caution.

It’s time for a brush up on the glossary of terms.  That’s where we go next.

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