Surrendering a Cash Value Policy? Don’t Waste the Loss

I see many misguided initiatives to drop cash value policies, coming from a guru’s generalization that “all whole life insurance is bad”, or an agent’s effort to make a new sale.  Dropping a cash value life insurance policy warrants careful consideration: calculating the real (not nominal) rate of return, comparing alternative investing strategies, assessing the current health of the insured, one’s current need for death benefit, and the taxation upon surrender.

If the policy is a poor value, no longer needed, and without a taxable gain, the common advice is to surrender.  Not so fast.  If there is no gain there must be a loss.  How much is it?  Could it be used to offset the gain on other life policies or annuities?  Often it can by merging the losses on some contracts with the gains of others, via a 1035 tax-free exchange.

I recently had two clients who were dropping cash value policies at a loss: the surrender value was less than the cumulative lifetime premiums. Normally upon surrender no tax deduction is allowed.  However, both these clients also had annuities with gains. Annuity gains are tax-deferred until withdrawn, and then they are taxed as ordinary income.  I’m not a fan of annuities, but these were unusual. One client’s annuity was issued October, 2007 (market peak before Subprime mortgage crisis) with the guarantee it would double after 10 years. The insurer bemoaned the day it made that guarantee, but it’s an elite annuity that shouldn’t be dropped (until after it doubles), when it will have a large taxable gain. The other client had a Fidelity no-load annuity, also with a gain.

Both clients were “self-insured” through other assets, healthy, and their whole life policy cash values earned a low rate of return, so terminating them was appropriate. Standard procedure is surrender since there’s “no gain”. However, the loss can be rolled into the annuities to offset its gain which must ultimately be recognized.

If there’s a loan on the life policy it must be paid off first and this can be a problem since you don’t want to stuff more cash into the annuity, particularly if it’s a commissionable annuity.   However, one could open up a commission-free annuity (Fidelity or Vanguard), pay off the loan, and then roll over the life policy (with its loss) into the annuity.  Once the rollover is complete, the cash could be withdrawn from the annuity, at least if the annuitant is over age 59 1/2, or if the loss totally or at least mostly negates the gain.

Again, I don’t like annuities, where the tax wrapper becomes the major selling point while the investments within languish in less than optimum strategies and subject to high transaction costs for most.  I’m only suggesting using them as a temporary tax strategy, and then get back to better investing strategies.

Withdrawals from annuities, before age 59 1/2 are subject to the 10% early withdrawal penalty, to the extent of the taxable gain, and it’s gain out first.  However, the loss of the life policy would reduce and sometimes eliminate that gain, so this penalty may become moot.

It’s important to only use commission-free annuities such as with Fidelity or Vanguard.

In summary, here are the four ingredients to make this work:

A poor cash value policy you want to drop, with a tax loss.

• An annuity or life policy with a gain or prospect of a gain.
• Preferably over age 59.5.
• A no-load annuity.

It’s a rare scenario that has all these elements, but with this happening with two clients in the same week, it may have broader application than I’d thought.

[I just did another case where “not wasting the loss” came in play, by retaining a whole life policy as a paid-up policy, since its cash value grew at 3.5%.  This client had no annuity with gains to offset, but an elite cash value policy.  This policy will be retained as an emergency fund substitute and until it’s loss becomes a gain (four of five years) the 3.5% return is essentially income tax free.  See, “Is Whole Life Viable for Anybody?” for the full story.]