Advisor Daniel Roe doesn't believe in letting the tax tail wag the dog, but when he gets a chance to minimize his clients' taxes without any drawbacks, he's all for it.

One such situation can occur when a client no longer needs his or her life insurance policy and rolls over the cash value into an annuity through a 1035 exchange. If the cash value of the life insurance policy is less than the total premiums paid, the difference between the two figures is the amount of tax-free growth that can occur within the annuity. Underwater cash values have occurred because of low interest-rate returns in whole-life and universal-life policies and because of plummeting equity values in variable and universal-variable policies.

Roe, a CFP and principal at Budros & Ruhlin Inc. in Columbus, Ohio, explained a recent situation in which a client owned a 20-pay whole-life policy and no longer needed life insurance. He had paid annual premiums of $4,100 over 10 years, for a total of $41,000, and the policy's cash-surrender value was about $18,000.

With Roe's help, the client rolled the $18,000 cash value into a low-cost annuity that's invested in the S&P 500 Index. "The decision to do the rollover was based purely on the ability to reap the next $23,000 in tax-free gains," says Roe, adding that he doesn't routinely buy annuities for clients. He finds annuities most appealing for situations such as this, when he wants to preserve the insurance tax basis that is higher than the policy's cash value, or when he wants to switch a client out of a high-cost annuity into a low-cost annuity while maintaining the tax deferral on the past growth.

Section 1035 of the Tax Code allows such exchanges without triggering any tax consequences at the time of the exchange. To qualify, the old policy and the new policy must have the same owner and the same insured person.

Exchanging the cash value of an underwater life policy into an annuity can be a relatively easy decision for the client who no longer needs life insurance. But Roe also considers it for clients who still need life insurance, assuming they are insurable and can obtain equally good new coverage at the same, or lower, cost. Surrender charges of the old policy should be considered, but often they are outweighed by lower costs in the new policy. "Very often, the best decision is to eat the surrender charges and move on," Roe says.

Replacement Policies Often Are Cheaper

Glenn Daily, a fee-only insurance consultant based in New York City, says he frequently recommends that clients replace their life insurance policies, regardless of whether their cash value is lower or higher than the premiums paid. The first consideration is to determine if the client needs a death benefit, and if so, how much. The next step is determining the client's health. If the client's health has declined and he is not insurable by another carrier, then he obviously needs to maintain the existing policy.

But if the client is healthy and can obtain a new policy, he often can purchase it at a lower cost than that of his existing policy, Daily says. That's especially true for healthy older clients who were underwritten many years earlier. This occurs because the pool of people currently being underwritten is healthier than the pool of people of the same age who were underwritten years ago. "The probability that a 70-year-old who bought a policy 20 years ago will die at age 70 is much greater than the probability that a 70-year-old who was just underwritten will die at that age," says Daily.

Daily provided a table that compares the expected mortality rate of a 70-year-old recently underwritten (shown in the "New Policy" column), with the mortality rate of another 70-year-old who was underwritten 20 years earlier (shown in the "Old Policy" column). As shown below, there's a .41% mortality rate in the first year for a 70-year-old who has just been underwritten, compared with a 1.62% mortality rate for a 70-year-old who was underwritten 20 years earlier. For the owner who bought his policy at age 70 and is now 71, the mortality rate is .63%, compared with a 1.8% rate for a 71-year-old who was underwritten 20 years earlier.

Daily says there's a common misperception that the older you are, the more expensive it would be to replace your existing policy. "It's actually the opposite," he says. "The older you are, the greater the difference between the mortality rate for people who were underwritten years ago and the mortality rate for people who go through underwriting again." The lower the mortality rate, he says, the lower the insurance company's costs and the lower the life insurance premiums.

If the cash value of the existing life policy is less than its basis, it's like icing on the cake. Not only will the client be paying less for the replacement insurance, but he'll also benefit from tax-free growth in the annuity up to the point where the cash value reaches the basis. Gains beyond that point would be subject to ordinary income taxes at the time of withdrawals. Of course, the cash value in one life insurance policy could be rolled over to a new cash-value life policy, but it's harder to access the tax benefits from a life policy than from an annuity, says Daily. That's why he recommends buying the new life policy with other available funds and rolling the cash value of the underwater life policy into an annuity, where it's less complicated to reap the tax benefits, assuming the annuity appreciates.

Daily believes so strongly in the tax benefits of this strategy that he claims it's tantamount to malpractice for advisors not to consider it. "Once you've determined that you don't want the life insurance policy, for whatever reason, what possible defense would you have not to do a 1035 exchange in order to preserve the cost basis?" he asks. He uses only no-load, low-cost annuities with no surrender charges. But the strategy also can work for commission-based annuities, he says, although some of the benefits are lost due to the higher costs.

David Walz, CFP, of Oak Park, Ill., is another advisor who uses the 1035 exchange strategy to allow tax-free growth for clients. He's in the process of rolling the cash value from three life policies owned by a client-who no longer needs a death benefit-into an annuity that has no surrender charges. Premiums paid into the policies total $12,000, and the cash value is $6,000. Since the client is not in a very high tax bracket, Walz says, he more than likely would surrender the annuity once its value reaches $12,000. At that point, the client can withdraw the entire $12,000 tax-free, including the $6,000 growth in the annuity.

Poor Markets Add To Deficits

Given the poor market performance over the past couple of years, there's a huge number of life policies with embedded losses, or "deficits," says TIAA-CREF's Michael Lane, referring to policies whose cash values are worth less than the premiums paid. "This concept of capturing the tax benefits through a 1035 exchange is very timely because of what's going on in market conditions," and it can apply to whole-life, universal and variable policies.

Many whole-life policies sold during the past 10 to 20 years incurred huge commissions, as well as high mortality and insurance expenses. The illustrations presented at the time of purchase indicated the policies would earn much higher interest rates than actually occurred. The result has been cash values that are far lower than had been expected and likely are lower than the premiums paid, even after 10 to 15 years.

The situation can be even more serious with variable policies that were purchased before the stock market declines over the past couple of years. "People who started variable life insurance policies over the past three to five years are not getting the 10% returns they were expecting," says Lane, who is manager of TIAA-CREF's advisory services. "Instead, they've been getting negative 10% to 20% returns, and now they're running the risk of having the policy lapse if they don't dump a lot more money in it."

If the client doesn't need permanent life insurance, Lane says, he can usually save premium costs by purchasing term life insurance-such as a 20-year, level-term policy. Using other available cash for the new life policy, he can then roll the original life policy-before it lapses-to an annuity, thus preserving the high tax basis.

Lane also cautions against surrendering an existing life policy before buying a replacement policy that has the desired coverage. He points to a personal situation that occurred a few years ago when his father was seeking a replacement life policy. During the health screening, doctors discovered a severe liver problem that prevented him from qualifying for the new policy. Fortunately, his father had not yet surrendered the old policy, and even more fortunately, his condition was treatable by medication because of its early discovery.

Mimi Lord, CFA, CFP, wrote this article while senior editor of MorningstarAdvisor. TIAA-CREF, her current employer, participates in the Due Diligence Center of www.morningstaradvisor.com. Lord can be contacted at [email protected]

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