TOLI Trustees Should Not Throw Away A Tax Opportunity With The Policy

We have previously written about how changes in the estate tax laws have some grantors questioning their need for a large tax-free death benefit.  We can provide many reasons why retaining a policy still makes sense, but there may be other reasons (bad policy performance, cost of insurance increase, etc.) that necessitate a policy replacement, or even surrender. The IRS allows a tax-free exchange for policies that have a tax gain (when the cash value is greater than cost basis) through a 1035 Exchange – a carrier to carrier transaction that transfers the cash value from the existing policy to a new policy. This method can also be used to move the cash value of life policy tax-free into an annuity.  (1)

So, what happens if a policy has no gain?  A 1035 Exchange is typically more cumbersome than simply surrendering a policy and starting a new one.  Considering there is more paperwork and the transaction process is typically longer, one may wonder why not simply surrender a policy that has no tax gain?  Because by surrendering the policy you pass up another benefit of a 1035 Exchange, which is the carryover of cost basis. 

Let’s look at an example: Assume your client has funded a current assumption universal life policy over 15 years at $20,000 per year.  The policy would have a cost basis equal to the total premium paid - $300,000.  Let’s further assume that the policy has a current cash value of $125,000.  If the policy was surrendered and the cash value was placed into another policy, the cost basis that transferred over would be $125,000 (Option #1). However, if the policy was transferred via a 1035 Exchange, the cost basis that transferred over would be $300,000, the cost basis of the existing policy (Option #2).  Option #2 allows you to keep an additional $175,000 cost basis, which is beneficial should the new policy be surrendered in the future. If the policy was exchanged for an annuity, the same $300,000 cost basis would transfer, again potentially sheltering up to $175,000 in gain.

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We come across trustees surrendering policies whose value is not the minimal cash value, but the cost basis that has accrued. Planning strategies for policies that will be replaced, and especially those that will be surrendered, should be developed based on trust characteristics (for example, grantor trust status may allow the grantor to obtain some tax benefits) and client (beneficiary) needs. 

Even a policy that has diminished value can still create more benefit for the trust and beneficiaries – and isn’t that the goal of a TOLI trustee?

1.) U.S. Code § 1035(a) states no gain or loss shall be recognized on the exchange of—

  • a contract of life insurance for another contract of life insurance or for an endowment or annuity contract or for a qualified long-term care insurance contract; or 
  • a contract of endowment insurance for another contract of endowment insurance which provides for regular payments
  • beginning at a date not later than the date payments would have begun under the contract exchanged, or for an annuity contract, or for a qualified long-term care insurance contract; or
  • an annuity contract for an annuity contract or for a qualified long-term care insurance contract; or
  • a qualified long-term care insurance contract for a qualified long-term care insurance contract.