A lot of people have aging life insurance policies of various kinds that are no longer needed and/or about to lapse. The normal course is to just let them lapse but with some planning, these various types of life insurance policies can be used to shield future taxable income. Here are some examples of how:
Joe has a $500,000 universal life policy that he bought 20 years ago. He has paid $20,000 in total premiums over the years, but the policy has not performed as projected due to very low interest rates and is now close to lapsing without value. If he no longer needs the insurance coverage, instead of just letting the policy lapse, he could exchange it for an annuity. There is a potential compelling benefit for recommending annuities in this case.
When Joe exchanges the life policy into the annuity, the annuity now has a tax basis of $20,000. That means he could deposit a lump of cash into the annuity and the first $20,000 of growth would be tax free. If Joe deposits $50,000 into the annuity and it grows to $70,000 over the next few years, at that point he has a $70,000 value with a tax basis of $70,000 ($20,000 exchange + $50,000 deposit). (For related reading, see: Cash Value vs. Surrender Value: What Is the Difference?)
With tax basis equal to value, the annuity can be surrendered with no tax (or 10% penalty even if he is under age 59½).
While most people would probably not think of the above technique, an even less understood possibility exists with term insurance. Assume now that Joe purchased a 20-year level term premium policy 20 years ago and has paid total premiums of $20,000. Now the premium is about to increase dramatically and Joe doesn’t need the insurance. Following the same logic above, he can exchange the term policy into an annuity and get the same result.
While this technique is generally accepted, it is important in this case to make sure ahead of time that the old and new insurance carriers will properly execute the exchange.
Besides the potential tax benefits, this strategy can provide a college financial aid planning bonus. Like retirement accounts, a deferred annuity is not a reportable asset on the Free Application for Federal Student Aid (FAFSA). If Joe is in the years leading up to his kid(s) applying to and paying for college, this would keep the $50,000 from showing as an available parent asset. The eventual withdrawal from the annuity, even if it is non-taxable, will be reportable as income on the FAFSA, so the timing of that withdrawal would be better if later in the kid(s) college years.
This approach has an advantage over a 529 college savings plan for two reasons. First, if the funds aren’t used for college, no big deal because the $20,000 growth isn’t going to be taxable in any case. 529 savings, with some exceptions, must be used for college expenses to get tax-free growth and avoid a 10% penalty. Also, assuming the 529 plan is owned by one of the parents, which is usually the case, it will be considered a parental asset in the FAFSA calculation.
Things to Consider
Several things should be considered when exploring such a strategy:
- Is there still need for life insurance and how can that need be met?
- Is an annuity, whether fixed, indexed or variable, an attractive investment vehicle in the scope of the total investment plan?
- Is there enough basis being carried over in the exchange to make this worthwhile? How much in taxes will be saved?
- What is the likely timing of withdrawal from the annuity and does that properly coordinate with other elements of the financial plan?
Also know that Section 1035, the tax code section that provides for exchanges among life insurance and annuities, is very specific and knowing what can and cannot be done is critical in getting this right. Just as in most financial planning applications, each set of facts calls for careful planning and application of the law. Before surrendering or lapsing that old policy that has run its course, see if there is an opportunity to repurpose into something that can add additional value going forward. (For more from this author, see: The Impact of New Tax Code on Financial Planning.)
Disclosure: Any information presented here is general in nature, believed to be reliable as of the date published and is not intended to be and should not be taken as legal, tax, investment or individual financial planning advice. Competent, licensed professionals should be consulted when implementing any kind of financial, estate, tax or investment strategy.