2005-08-11 / Business & Finance

Section 1035 May Spell R-E-L-I-E-F

To borrow an idea from the advertising industry: “How do you spell relief?” No, the answer is not Rolaids. In this case, it’s 1035. Section 1035, a section of the Internal Revenue Code, is a provision that allows for life insurance and annuity exchanges. Many people at retirement find that they no longer need the life insurance coverage they have. Why, you may ask?

One of the main uses of life insurance is to replace the earnings of a breadwinner. Since there are no more earnings at retirement, there is not need to insure them. In fact, should one party die, the survivor, in many cases, is better of financially because expenses are lessened. This would not be true, however, if a deceased spouse was receiving an annuity payment which ceases upon their death. Assum-ing this is not the case, many people have life insurance policies they no longer need.

If the policy(s) is term insurance, it can be terminated by not paying any more premiums. However, if the policy(s) is a permanent product, you might want to consider a Section 1035 transfer.

Of course, you could surrender the policy and put the proceeds in your pocket, but consider this first. If there were a gain in the policy, you would owe taxes on that gain. Let’s say that you paid $10,000 premiums over the life of the policy. If the surrender value were $20,000, you would owe taxes on that gain. Similarly, if you paid $20,000 in premiums and the surrender value were $10,000, you would not owe any tax because there is no gain, but you would be blowing a $10,000 tax loss.

A 1035 exchange form a life insurance policy to a deferred annuity is the answer to these problems. A de-ferred annuity is a contract issued by a life insurance company. It has an advantage over many accumulation vehicles such as bank accounts, mutual funds, et. al. In that gains in an an-nuity are tax-deferred i.e., you don’t pay taxes on those gains until you take them out.

There are two types of annuities - fixed and variable. Fixed annuities pay interest rates similar to certificates of deposit. Variable annuities offer mu-tual fund type accounts; hence, their results vary.

Getting back to the two situations outlined above, let’s see how a 1035 exchange does the job. In the first example where you paid in $10,000, received $20,000, and paid tax on $10,000, by using a 1035 exchange form a life insurance contract to an annuity, there would be no tax due until you withdrew money from the annuity. In the second example, where you paid $20,000 and received $10,000, by exchanging via a 1035, you would carry the $10,000 loss into the annuity. This means that you would not have any taxable income until the value of the annuity grew above $20,000.

Variable annuities have some interesting bells and whistles these days. You can get guarantees on death benefits, investment returns, and money paid to you. Additionally, you can an-nuitize the contract and receive a stream of income that you cannot outlive.

However, you need to watch out for a few things. If you have a loan on a life insurance policy that you are exchanging, pay the loan off first. An annuity cannot accept a loan; therefore, outstanding loans become taxable.

Also, because annuities have surrender penalties, they are not short contracts. It is important to make sure you fully understand how they work before you make any changes.

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