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 “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 Annuity gains are tax-deferred until withdrawn, when they are taxed as ordinary income.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 a vintage 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 the life policies were poor quality, so termination 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 Once the rollover is complete, the cash could be withdrawn from the annuity, at least if the annuitant is over age 59 1/2, or if the loss totally or at least mostly negates the gain.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. 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 elements present, but with this happening with two clients in the same week, it may have broader application than I’d thought.

My Experience with Tax-deferred Annuities

My first step into annuities was in early 1987 when an agent. I sold annuities to two business owners to fund their IRAs. I put these in a variable annuities just before Black Monday shrunk the Dow over 20% in a day. I had conflicted emotions, sick over what had just happened, while excited about my forthcoming wedding to my dear wife on 12-05-87.

Fast forward 20 years. By this time I had left sales and “graduated” to no-load annuities. In 2007 a client insisted I managed his Fidelity annuity. He owned a tax service and was enamored with the tax-deferred nature of annuities. I acquiesced just before the subprime mortgage crisis shrunk the stock market over 50% in 17 months. “Déjà vu all over again.”

With deferred annuities you still have to reckon with the same basic investing decisions as with mutual funds. Are you a lender through a fixed annuity or an owner through sub-accounts tied to the stock market within a variable annuity? Most agents promoting annuities will make much ado about tax deferral, but that’s the tail, not the dog. The bookends that frame my experience with annuities rivet my attention on something far more consequential than tax deferral.

Investment strategy should always trump tax strategy. There are sound investment strategies that have solid defense that will fare much better through protracted multi-month market declines such as the tech bubble burst of 2000-2002 or the subprime mortgage crisis of 2007-2008. However they require two primary elements that annuities, even the best no-load varieties such as with Vanguard or Fidelity, do not offer: the ability to trade more frequently and options that are dissimilar to the stock market, such as gold or even inverse ETF’s.

In doing research for a recent article for Sound Mind Investing (March, 2013) I had several extensive talks with the annuity department at Vanguard. One oft repeated expression I heard was, “If you believe in the stock market” (you might want to use a variable annuity). I have reservations that the stock market will always go up given enough time. Remember when we always considered real estate an appreciating asset?

Consider this. The catalyst of the 2007 subprime mortgage crisis stock market debacle was unwise government intervention, a mandate to issue loans to people whom banks had recognized for millennia were bad risks . Such wholesale disregard of economic laws had repercussions. Government cannot defy economic laws any more than command the ocean tide or rising sun.

Their answer to the problem, in the words of Ayn Rand, was more of the same poison that precipitated the initial problem – bad debt, borrowing trillions we cannot repay. More bad seeds will produce another bad crops, though when and how we cannot know.

Scripture says, “A prudent man sees evil and hides himself, the naive proceed and pay the penalty.” Proverbs 27:12. Good investing strategy needs good defense. Annuity’s defense is weak, due to limited options and restricted trading frequency. To be dazzled by the tax-deferred nature of an annuity is misplaced focus- on the tail, not the dog.