By Daniel McDonald
Do you have any whole life insurance policies? Unlike the more common term insurance, whole life insurance costs more but unlike term insurance can build cash value, fix premiums for many years even if health deteriorates, and provide certain tax benefits including tax-free loans. A 1035 exchange is a great option to consider for capturing the value of life insurance for retirement tax efficiently.
Perhaps you have an old policy with significant cash value more than premiums paid. Especially if you are retired, you may not need life insurance anymore.
What can you do with an old whole life insurance policy? One option is to cash out the policy and invest the proceeds. Cashing out, however, probably creates taxable income and loses any tax benefits. The taxable portion of the cash value may be significant, especially if the policy issued many years ago.
The 1035 exchange from whole life insurance to an annuity
Fortunately, there is an alternative, tax-efficient way to convert the cash value of old whole life insurance policies that may be worth a look: a 1035 exchange. Under Section 1035 of the Internal Revenue Code, you may exchange a life insurance contract held outside of an IRA or 401(k) for any of several alternative contracts: another life insurance contract, an endowment contract, an annuity, or a long-term care insurance contract. Importantly, you do not need to recognize any taxable gain at the time of the exchange. Moreover, the cost basis of the former insurance product carries over to the new product, lowering taxes when they become due.
An exchange for an annuity could, for example, provide a guaranteed future fixed income source for a 65-year-old who may live into his or her 80’s or 90’s.The guarantee may be appealing, especially if you win the longevity lottery and keep the ticker going past 90. As my book, Savvy Saver’s Guide to Deferred Annuities discusses, however, the guaranteed nature of payments comes at a price. That price includes not only fees and devaluation of future payments due to inflation, but the lost opportunity to participate in potential stock market gains over the long term.
The deferred variable annuity: worth considering for longer time horizons.
A deferred variable annuity is another potential candidate for a 1035 exchange. It provides a vehicle to invest in a variety of mutual funds and perhaps other investments. It provides a chance to participate in the stock market. Payments are not fixed or guaranteed—the insured bears the risk of market declines. For longer time horizons, in the range of 20+ years, however, a stock-market index fund investment, for example, may be worth considering for at least part of the amount converted. Index funds, such as ones tied to the S&P 500, historically have fluctuated along the way, and may be too risky for shorter time horizons. But by the end of most 20+year time periods such funds have historically appreciated consistently, at a rate corresponding to average growth of at least about 7% – 8% per year. Moreover, this growth compounds in a variable annuity on a tax-deferred basis, incurring no taxes until withdrawals begin.
A basic deferred variable annuity provides flexibility rather than guarantees. One may invest and withdraw largely as they deem fit. For example, Fidelity offers the Fidelity Personal Retirement Annuity® which offers the opportunity to invest in a family of over 65 mutual funds, including several stock and bond index funds, international funds, sector funds, fixed income funds, and money market funds, which together cover a range of risk and potential return options.
No taxes are due on a variable annuity until there is a withdrawal or an income payment. Even then, the taxable portion will exclude after-tax premiums paid into the former insurance product (and any new after-tax contributions made after conversion). This vehicle might be particularly appropriate for investments and trading that are not tax efficient outside a tax-deferred account, such as investments generating significant interest income, nonqualified dividends, or capital gains.
No RMD
One interesting feature of the variable annuity is that it is NOT subject to Required Minimum Distributions (RMDs). This means that 100% of the value can work for you for as many years as the annuity contract allows, even into your nineties, without any requirement that you start draining the account earlier to give the IRS its cut. This feature provides more flexibility and control over taxable events than does an IRA or 401(k) subject to RMDs. In most states, the Fidelity contract requires no withdrawals until age 95. There is no IRS contribution limit either. See www.Fidelity.com/FPRA for more information on the Fidelity version (I do not get compensated in any way by Fidelity for saying anything nice about them).
You may convert a deferred variable annuity later into immediate, systematic payments of a desired amount for life, or used for variable withdrawals. You can plan to use this income source in 20 years, for example, but access it sooner if plans change. Just be careful about any withdrawals before age 59 ½, which (as for IRA withdrawals) may trigger a penalty.
What is the catch? There is a fee in addition to the normal fees charged by the mutual fund providers. In Fidelity’s case, the annuity fee is relatively low: 0.25% of the annuity value each year for annuities under $1 million. That fee reflects a no-frills annuity. For example, there is no guaranteed minimum value of the annuity on the owner’s death—beneficiaries get the then-current value, which may be below the total amount invested in the annuity. That, however, may be a risk you (on behalf of your esteemed beneficiaries) are willing to take, in exchange for the reduced fees that should contribute to a higher overall return over time. In any event, fees vary, so be sure to watch out for high fees.
Warnings
Any conversion should be handled by the financial institution receiving the converted funds. The conversion must be direct. If the insurance policy has outstanding loans, that may well reduce the benefits of an exchange.
Protection from insolvency varies by state. A $250,000 cap on the insured portion of an annuity is common. Protection of the annuity value from creditors may also vary by state.
Make sure that you have a complete understanding of any fees and commissions assessed against the new product. Some fees, for example, may apply to add-on features you do not want.
Also, consulting with an advisor might reveal that an alternative type of annuity or insurance product is a better fit for the insured. For example, if health issues preclude the insured from buying cost-effective life insurance today, that might be a reason to maintain insurance. Long-term care insurance may be a preferred option. Surrender fees may apply and should be considered as well. A partial exchange into a mix of uses also may be a better option.
Most states provide for a “free look” period of about 10-30 days where you can change your mind. After that, however, keep in mind that you cannot convert back from an annuity to life insurance. 1035 is a one-way street in that sense. During the free-look period, the insurer may need to deposit proceeds into a low-risk investment such as a money-market fund.
Is a conversion right for you?
Exchanging whole life insurance for a low-cost variable annuity, with a significant percentage invested in the stock market, may provide long-term benefits for someone living longer than average. Sure, the value will fluctuate and may go down before all is said and done. But as a potential inflation hedge and source of income in the 20-plus year range, the chances of seeing the value increase more in the variable annuity than as cash value of whole life insurance may be appealing.
The bottom line: Regardless of whether you are a fan of annuities in general, if you have cash value in a whole life insurance policy more than premiums paid, a 1035 exchange may well be worth a look. This is especially true if your situation has changed such that holding the life insurance policy does not make sense anymore. Consider talking to a financial advisor about whether a 1035 exchange makes sense for you, and if so, about how to find your best exchange option. Nothing herein is to be construed as providing financial advice. See website for disclaimers.
