Let’s start with the one about the mathematician who hated negative numbers. He would stop at nothing to avoid them. Think about it for a minute.
Insurance advisors don’t like negative numbers either, especially when they represent losses inside an insurance or annuity product. And too often the response is to cut and run, throw in the towel and surrender the policy and then attempt to avoid negative numbers in future purchases.
But maybe an advisor would do better to encourage the client with words of Gladys Knight and the Pips when they resolved, “I’ve really got to use/ My imagination/ Got to make the best of/ A bad situation.” And the good news is that IRC 1035 is ready to help you “Think of good reasons?/ To keep on keepin’ on,” rather than just lapsing the contract.
A 1035 exchange is too often seen only as a strategy to protect a gain in a transaction.
The planning opportunities multiply if two other aspects of the Code section are kept in mind: first, an exchange can also preserve a loss and, second, a life policy can be exchanged for an annuity on a non-taxable basis. Consider an existing VUL with a basis (usually the amount of premiums paid) of $200,000 and a surrender value of $50,000, all resulting in a current $150,000 loss.
Some strategies involving an annuity are (and they get better as you go along):
Roll the $50,000 to an annuity
The basis is still $200,000. There is room for $150,000 non-taxable growth. New money can be added at the time of the exchange to more quickly take advantage of the loss. For example, add $250,000 of new premium to the $50,000 rollover. Now the policy has $300,000 with the ability to grow $150,000 on a non-taxable basis.
Surrender the exchanged-for annuity later
If you get tired of waiting to take advantage of the full $150,000 loss, ask a tax advisor of the results of a surrender. He or she may agree that the remaining unused loss is deductible against ordinary income – refer to this short article here.
Take advantage of the loss now
Assume that the client also has an existing annuity with a basis of $100,000 and a surrender value of $200,000. Two-for-one exchange both the loser-VUL and the annuity into a new annuity. The result is a contract with $250,000 in cash value and a basis of $300,000. The current gain in the old annuity is protected from future taxation and there is still room for $50,000 of non-taxable growth!
Don’t surrender any policy until all product alternatives have been considered, especially those afforded tax advantages under section 1035. Even then things must be done in good order so call concerning cases you have involving the disposition of an unwanted policy in anticipation of the purchase of another.
Back to mathematicians: Do you ever wonder why there is no Nobel Prize awarded in the field of mathematics? One widely-offered explanation is that it is because a mathematician named Gosta Magnus Mittag-Leffler ran off with Nobel’s wife. The only hole in that theory is that Nobel never married, proving again that you can’t believe everything you read – except for this article.