by fbrandt » Tue Dec 07, 2010 12:23 pm
I have a life ins. policy that has 120,000 cash surrender value. My cost basis is about $40,000. Can I withdraw my cost basis tax free and put it in my pocket, and take the $80,000 gain and do a tax free exchange into a new life ins. policy. If the answer is yes, what section of the IRC is this covered by?
Posted: Tue Dec 07, 2010 05:18 pm Post Subject:
Exchanging an existing life insurance contract for another life insurance or annuity contract is provided for under Section 1035 of the IRC. Generally, everything must be identical in the new contract compared to the old contract.
If you are not taking the entire cash value and cost basis into the new contract, you may be creating a taxable event. You need to speak with a tax adviser (not an insurance agent) about this. If I understand the IRC correctly, you cannot do what you are asking, as the new contract will have no cost basis.
Partial 1035 Exchanges are permissible under certain circumstances. It usually requires the original contract to remain in force after the exchange. Again, your tax adviser will know the answer based on your income tax situation.
You can always borrow the money from the death benefit with no immediate tax consequence, as long as the amount borrowed plus accrued loan interest does not exceed your cost basis. In such an event, if the policy were to be terminated other than by the death of the insured, the only taxable event would be on any excess over basis.
Understand, however, if you have a Universal Life/Variable Universal Life policy, borrowing from cash value causes the "Net Amount At Risk" (NAR) to rise, increasing the monthly cost of insurance based on your age. This can have a negative effect on the cash accumulation, which can accelerate over time. If the policy later lapses due to nonpayment of premium, and the remaining cash value has been eroded by "automatic policy loans", that "borrowed" cash value represents what was once gain, and there will be a taxable event on all the money taken out of the policy other than the cost basis -- even though you never physically touched it.
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