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Watch out for the whole life tax trap! Older whole life products could be setting your clients up for pricey tax bills down the road. find out how to help them avoid the trap or, if it's too late, how to get them out.


Mr. Client purchased a $10,000,000 participating whole life policy in the late 1980s. He -funded the policy with $ 100,000 annually for three years and then stopped making premium payments.

The particular whole life policy he bought was designed, like most whole life policies, to be funded every year. If a premium payment was not made, the policy would be terminated, and he would be sent a check for the cash surrender value. However, Mr. Client's policy also had a feature called Automatic Premium Loan. If he skipped a premium payment, the insurance company would take a loan out against the cash surrender value and use the loan proceeds to make the premium payment for him.

Modern universal life products credit interest directly to the policy's accumulation account. In older whole life products, interest was not credited inside the contract--instead, the policyholder received dividends and chose one of several available dividend options. Mr. Client elected the Paid-Up Additions option, which meant his dividends were used to purchase extra amounts of paid-up insurance. The paid-up additions also had their own cash surrender value.

On paper, Mr. Client's policy appeared to be performing well. The insurance company was financially stable and paid good dividends. The base policy continued to build cash surrender value, and the amount of paid-up additional insurance grew every year. Because he was no longer making premium payments, the policy loan also grew every year, and because he was not paying interest on the policy loan, interest was capitalized and added to the loan balance.


This is where Mr. Client fell into the whole life tax trap.

After 20 years, the gross cash surrender value of Mr. Client's policy was $4,000,000, and the outstanding policy loan was $3,500,000. On a cash basis, he had paid in $300,000 and would receive $500,000 if he surrendered the policy. On the surface, this seems like a fairly decent result after 20 years, especially since he had a $10,000,000 death benefit during the entire period. Mr. Client received a rude awakening when the tax impact of surrendering the policy was explained.

For tax purposes, Mr. Client's cost basis is the total premium he paid in cash, plus the amounts paid on his behalf via the automatic premium loan mechanism. The policy's required premium payments were $100,000 per year over 20 years, so his cost basis in the policy was $2,000,000.

Mr. Client's taxable gain is the sum of the cash he receives on surrender of the policy, plus the amount of debt discharged, minus his cost basis in the policy.

Even though he would receive only $500,000 in cash on surrender of the policy, Mr. Client would have to report $2,000,000 worth of income. With a 34% marginal tax rate, he would have to pay $680,000 of taxes--the tax bill on surrender of the policy would consume the entire cash surrender value he received, and he would have to pay an additional $180,000 of tax out of pocket.

At this point, Mr. Client is livid--he can't believe he paid $300,000 for an insurance policy and ended up with a $680,000 tax liability. To make matters worse, the insurance company recently lowered its dividend scale, and the policy is projected to reach zero net cash value and lapse within a few years.

Escaping the Tax Trap

Mr. Client has a few options. He can ignore the problem, but this won't make it go away. The policy may run for a few more years, but eventually it will run out of borrowable cash value. If he does not resume premium and interest payments, the policy will lapse. When it does lapse, the tax problem will be even larger, and he won't receive any net cash to put toward the tax bill.

Another alternative is to do a partial surrender and use the proceeds to pay down the policy loan. This might buy some additional time, but it is unlikely to be a permanent solution if the policy is already in danger of lapsing. Mr. Client might be tempted to do a partial surrender to reduce the loan and then use a section 1035 tax-free exchange to move the remaining cash value and policy loan balance to a new contract. This would be very dangerous. The amount of the loan paid off would be recognized as taxable income to the client if he had a gain in the policy, even if he otherwise met all of the requirements for a 1035 exchange. *

The only safe way for the client to replace the policy is to do a 1035 exchange first, with the entire loan intact, and then, at some future time, do a partial surrender in the new policy to reduce the outstanding loan balance. A few insurers have 1035 rescue programs and products designed to accept large policy loans. Ultimately, one of these rescue products may be the only way for Mr. Client to avoid a large tax event.

Whenever you are reviewing existing life insurance policies or evaluating a 1035 exchange, make sure you look out for the whole life tax trap!

* If a partial surrender is used to pay off part of the loan and then the remaining policy is immediately exchanged for a new one, the step transaction doctrine would be applied, and the amount of debt discharged would be taxable boot to the extent that the client had a gain in the contract.

Creekmore Insurance Group is a full-service life insurance brokerage specializing in impaired risk and jumbo life cases, serving independent agents, agencies and financial advisors. Matt Treskovich is Creekmore's CFO and oversees advanced case design and underwriting. He can be reached via email at or at 800-936-0339. For more information, visit

By Matthew A. Treskovich, MBA, CMA, CLU, ChFC, FLMI
Calculating the Taxable Gain on Surrender

Net Cash Surrender Value $500,000
Outstanding Policy Loan +$3,500,000
Basis in the Contract -$2,000,000
Taxable Gain (Loss) $2,000,000
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Title Annotation:WHOLE LIFE
Author:Treskovich, Matthew A.
Publication:Life Insurance Selling
Date:Jan 1, 2011
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