Exchanging life insurance and annuity contracts.

Recent insurance industry troubles have prompted many policyholders to review their insurers' solvency. The result: Policyholders are replacing old life insurance and annuity contracts at a rapid rate. Another contributing factor is that since interest on personal loans no longer is deductible, it may not be appropriate to carry minimum-deposit insurance policies.

Internal Revenue Code section 1035 permits a tax-free exchange of certain life insurance and annuity contracts. It allows an old contract's tax basis to be carried over to a new one. Moreover, it provides for continuous tax deferral of a contract's accumulated earnings. So-called section 1035 exchanges are useful, but often overlooked, financial planning tools.

CPAs may find some clients asking when and how to effect policy replacements and should in fact advise all clients to review existing insurance and annuity contracts. With high commission rates, insurance agents have a vested interest in recommending replacements. Since a number of financial and tax factors must be considered, the CPA may be in the best position to help a client make an objective determination about the appropriateness of using a section 1035 exchange to replace a policy.

While there are many reasons for replacing old policies, several factors should be considered in determining if policy replacement is necessary or wise. This article discusses the factors to consider when evaluating policy replacement and offers planning tips for executing a section 1035 exchange.

WHY REPLACE OLD POLICIES?

Replacing existing insurance or annuity contracts with new ones may be a good idea for several reasons. Insurer solvency. While a client's current coverage may be appropriate, policy replacement may be necessary because the insurer's financial stability is questionable. A few years ago, the typical concern was finding the highest interest rate, but today consumers are more interested in an insurer's financial stability. Their stampede to insurers that are financially secure has been called the "flight to quality."

Four agencies rate insurance companies' financial strength: A. M. Best, Duff Phelps, Moody's Investors Services and Standard & Poor's. As a rule of thumb, an insurer receiving the highest or second-highest rating from at least two rating agencies is considered financially safe provided it is not rated below the fourth level by any agency.

Improved insurability. Changes in client circumstances may make a new policy appropriate. For clients who stopped smoking, for example, more favorable terms may be available from some companies. (Some insurers, however, may agree to reunderwrite an existing policy.) In other cases, nonsmoking rates may not have been offered when the policy was purchased.

Changing mortality rates. Because people are living longer, the cost of death protection on new policies is lower than on older policies. Clients with old nonparticipating policies (which don't earn dividends) that don't reflect updated mortality experience may benefit by replacing them with policies with lower premiums or higher death benefits. It is not necessary to replace participating policies--dividends typically increase because of decreased mortality charges. Similarly, it's not necessary to replace universal life policies-premiums or face values can be adjusted to accommodate mortality-charge changes.

Increased rates of return. The rates of return on old cash value policies may not be competitive. Again, it may be necessary to replace only nonparticipating policies that have not been upgraded. On participating policies, dividends typically reflect rate-of-return changes and universal life policies already are designed to accommodate such changes.

Ownership problems. A policy may be co-owned by individuals whose relationship has changed, such as through a divorce or the dissolution of a business. Replacing the policy and naming a new owner may be an easy way to solve the problem.

Changes in financial situation. A client's current policy may no longer meet his or her financial needs. For example, some policies are structured with low premiums and high death benefits (for young clients with growing families) but have no savings element. A client's circumstances may evolve to the point where there is no need for high death benefits and wealth accumulation for retirement is preferred. Many universal life policies are designed to accommodate such changes.

Too many policies. It may be advisable to consolidate several policies purchased over a period of years into one comprehensive policy for ease of administration.

FACTORS TO CONSIDER

Even when the above factors point to policy replacement, there are several others CPAs should consider before recommending an exchange.

Uninsurability. A client may be unable to obtain a new policy because he or she is uninsurable due to poor health.

Incontestability clause. Most insurance policies have such clauses to prevent an insurer from voiding a policy after a certain period--typically two years. If the contestability period has expired, the insurer cannot refuse to pay on a policy, even if the insured dies from a preexisting medical condition not disclosed during the application process. A new policy starts the contestability period over again.

Acquisition costs. Because clients incur some costs when acquiring a new policy, the policy's additional benefits must be sufficient to justify replacement.

Cancellation penalties. Most annuity contracts have substantial cancellation penalties in the first five to seven years. The penalty period starts over on a new contract. Again, a new contract's additional benefits should outweigh the penalties.

Tax rules. Under the Tax Reform Act of 1984, annuity contracts issued after January 18, 1985, are subject to certain distribution requirements applicable at the owner's death and designed to prevent protracted tax deferral through successive ownership of the contract. Annuity contracts issued after that date in exchange for contracts issued earlier are considered new contracts and are subject to these rules. The drawbacks of the distribution requirements may outweigh a new contract's benefits.

WHY A SECTION 1035 EXCHANGE?

From a tax viewpoint, every cash value life insurance policy has either a gain or a loss. A policy has a gain (loss) if its cash surrender value is more (less) than its tax basis--generally, the sum of premiums paid less any tax-free distributions such as partial surrenders or dividends. When policies are cashed in, the IRC does not treat gains the same way it treats losses. Gains are taxable but losses are not deductible.

Section 1035 exchanges can be useful tax planning tools for both gain and loss positions by deferring gains or preserving a favorable tax basis in the case of losses. Exhibit 1, above, provides an example of each. When circumstances warrant policy replacement, a section 1035 exchange may be the tax-wise way to do so.

SECTION 1035 RULES

Section 1035 exchanges are not always possible. Exhibit 2, page 70, shows the types of exchanges permitted.

For the exchanges listed in exhibit 2 to be tax-free

* Both policies must be on the life of the same insured if the exchange involves life insurance (or endowment) policies.

* Both contracts must be payable to the same person if an annuity contract is exchanged for another annuity contract.

* The person insured under a life or endowment policy must be the person to whom the annuity contract is payable if a life (or endowment) policy is exchanged for an annuity contract.

When additional payments of cash or other property (the "boot") accompany an otherwise tax-free exchange under section 1035, gain is recognized to the extent of the boot received. A contract acquired in a taxfree exchange takes the basis of the contract exchanged for it, reduced by the boot received and increased by the gain recognized. A loan on an old policy discharged in an exchange constitutes boot and gain is recognized to the extent of the discharged loan. If the new policy's indebtedness equals the old one's, the exchange may qualify as a section 1035 exchange.

PLANNING TIPS

Section 1035 exchanges are complicated, so CPAs should understand some planning considerations in advising clients.

Excessive premiums. According to the Technical and Miscellaneous Revenue Act of 1988, a policy with excessive premiums in its first seven years is a modified endowment contract (MEC), which triggers adverse tax consequences. For example, distributions during an insured's lifetime are taxed on a last-in, first-out basis: Distributions are treated as earnings first and taxfree recovery of basis second. Moreover, taxable distributions may be subject to a 10% premature withdrawal penalty if the taxpayer is under age 59/2.

A section 1035 exchange from an MEC policy results in a new MEC policy. Although an exchange from a non-MEC policy retains its status, any premiums in addition to the old policy's cash surrender value may result in the policy's classification as an MEC. Thus, if a client wishes to buy additional coverage and the added premium violates the MEC limit, he or she should buy the coverage through a separate policy. If additional premiums inadvertently exceed MEC limits, most companies will refund the excess amount.

Policy loans. There are no Internal Revenue Service regulations on how to treat outstanding policy loans during section 1035 exchanges. (Private letter rulings do, however, provide clues to the IRS's thinking on the matter.) As mentioned earlier, a loan on an old policy discharged in an exchange constitutes boot--gain is recognized to the extent of the loan discharged. However, if the outstanding loan is carried forward to the new policy, the exchange is tax-free.

Some companies do not issue new policies with outstanding loans. Clients wishing to exchange policies with loans may have to shop around to find a company that will permit it. Alternatively, a client can repay the loan on an existing policy before it is exchanged and immediately take out a loan on the new policy.

Lump-sum premiums. Exchanges involving a transfer of cash values from one policy to another are not possible if the new policy (such as a conventional whole life policy) does not accept lump-sum premiums. Such exchanges can be accomplished by transferring the cash value to a policy that accepts lump-sum premiums, such as a universal life policy.

Timing. CPAs should make certain the new policy is in force before the old policy expires.

Multiple policies. Since exchanging a single policy for multiple policies entails allocating the old policy's tax basis, many companies do not accept such exchanges. Also, there is no explicit IRS guidance on allocation. Most companies will accept an exchange of multiple policies for a single policy.

Grandfather provisions. Tax-free exchanges of annuity contracts issued before August 13, 1982, retain some of the tax breaks applicable before the Tax Equity and Fiscal Responsibility Act of 1982. For example, the penalty-free withdrawal of principal, while leaving earnings in the contract, is retained under a grandfather provision. To enjoy this tax break, the company must note in a new policy's records that the annuitant wishes to retain penalty-free withdrawal for applicable amounts.

Exchange versus surrender. The distinction between making a section 1035 exchange or surrendering an old policy and purchasing another is not clear. Care must be exercised when exchanging one policy for another. For example, if an annuity contract is assignable, a direct transfer of funds between insurance companies is required for the transaction to qualify as a section 1035 exchange. On the other hand, if an annuity contract is nonassignable (for example, one distributed from a pension plan), a transaction in which the annuitant immediately endorses the check and surrenders it to the new insurer may qualify as a section 1035 exchange if it is executed as a single transaction under a binding exchange agreement with the new insurer.

Tax reporting. When an insurance policy is exchanged, the company whose policy is exchanged should issue a form 1099-R to the taxpayer showing the transaction to be a section 1035 exchange. However, the company may issue a 1099-R that incorrectly shows it to be a taxable surrender. CPAs may need to contact the company and ask it to issue a corrected 1099-R, or the transaction can be treated as a section 1035 tax-free exchange and documented on the client's tax return.

PROS AND CONS

As financial advisers, CPAs can review with their clients the pros and cons of replacing insurance and annuity contracts and help them decide if replacement will meet their personal and financial needs. If a decision is made to replace one or more existing policies, the CPA can get involved at an early stage to make certain the transaction is characterized as a section 1035 exchange.

EXECUTIVE SUMMARY

* INSURANCE INDUSTRY FAILURES have prompted many policyholders to review companies' solvency. As a result, they are replacing insurance and annuity contracts at a record rate.

* INTERNAL REVENUE CODE section 1035 permits a tax-free exchange of certain life insurance and annuity contracts--an old contract's tax basis is carried over to a new one.

* IN ADDITION TO CONCERNS ABOUT insurer solvency, reasons to replace insurance and annuity contracts include improved insurability, changing mortality rates, rising interest rates and changes in the insured's personal or financial circumstances.

* AMONG THE FACTORS CPAs should consider in advising clients about section 1035 exchanges are potential uninsurability, acquisition costs, cancellation penalties and unfavorable tax rules. An exchange should be made only if the advantages outweigh the disadvantages.

* BECAUSE SECTION 1035 exchanges are complicated, a clear understanding of the rules is essential. Potential problems include excessive premiums, tax treatment of policy loans, lump-sum premiums, allocating basis among multiple policies and making sure a transaction is characterized as a section 1035 exchange.

EXHIBIT I

Treatment of gains and losses

Example: Herbert Smith, who is near retirement, has an insurance policy with a $250,000 cash surrender value and a tax basis of $1 00,000. If the policy is surrendered, there will be a $1 50,000 gain.

Smith wants to annuitize the policy so it provides retirement income. Since the annuity rates offered by his existing insurer are not very competitive, he wants to buy an annuity from a differen carrier. Instead of surrendering the policy and investing the proceeds with a new company, Smith should execute a section 1035 exchange. Instead of being taxed immediately at surrender, the $150,000 gain will be deferred and taxed as annuity payments are received.

Example: Mary Carson recently purchased a life insurance policy that was issued on a substandard basis. Therefore, the policy shows a significant loss--the tax basis exceeds the cash surrender value. If for any reason Carson wishes to switch insurance carriers, she would be wise to do so through a section 1035 exchange. Both the tax basis and the cash surrender value on the old policy can be carried forward into the new contract. The loss is carried forward to offset future policy gains. If she simply surrenders the policy and buys a new one, the loss on the old policy will be wasted, since losses on insurance contracts are not deductible.

EXHIBIT 2

Allowable section 1035 exchanges

From                     To
Life insurance policy    Life endowment policy
Life insurance policy    Endowment contract
Life insurance policy    Annuity contract
Endowment contract       Endowment contract(*)
Endowment contract       Annuity contract
Annuity contract         Annuity contract

(*) Payments under the new contract must begin no later than the date payment would have begun under the old contract.

LABH S. HIRA, CPA, PhD, is professor and chairman, of the departments of accounting and finance at Iowa State University, Ames. A past member of the American Institute of CPAs employee benefits taxation committee, he is a member of the American Accounting Association, the Iowa Society of CPAs and the American Taxation Association.