TAX NEWS - 2010

U.S. Tax: Section 1035 is benefical part of tax code

The Internal Revenue Code is an amalgamation of rules and procedures pertaining to income, estate and gift taxes. The latest estimate is that Americans spend more than $200 billion each year in tax compliance costs, and tax experts are much in demand in every business.

One section of the tax code - section 1035 - is actually quite beneficial to taxpayers, since it allows an owner of an annuity or life insurance policy to exchange that policy for a new one without having to pay any income tax on any gains that may have accumulated in the old policy. For example, I can exchange any type of annuity policy for a new annuity policy, and my cost basis in the old policy is carried over to the new policy. However, if I ever surrender an annuity or life policy, I am required to report any gain as taxable income at that time, and the insurance company will send you and the IRS a 1099 form, setting forth the gain.

The rules surrounding 1035 exchanges are straightforward: I can exchange an annuity policy for another annuity policy; I can exchange a life insurance policy of any ilk for a new policy; or, I can even exchange a life insurance policy for an annuity policy, but I cannot exchange an annuity policy for a life insurance policy. I can also exchange two policies for one new one, as long as I am the insured on both of the old policies. Partial exchanges are also available.

One important provision to avoid any taxation is to ensure that the actual transfer of funds from the old policy to the new is handled by the insurance companies without any monies passing to the policy owner.

Even though these exchanges may be tax free, they are referred to as "replacements" by state insurance departments, and are subject to regulatory scrutiny to ensure that unsuspecting policy owners are not ripped off by unscrupulous life insurance agents. Basically, there must a compelling benefit to replace one policy for another.

Here are some reasons why one might want to take advantage of this tax favored treatment:

- Mortality costs may have improved since you purchased your original life insurance policy, and you may actually be able to save money, even though you are older.

- You may have concerns about the financial stability of the company that issued the original life insurance or annuity policy.

- Newer policies may have desirable features that were unavailable when you purchased your original life insurance or annuity policy.

- The old policy may be under-performing.

On the other side of the coin, you may choose not to exchange due to the fact that the new policy will require new expenses to be paid, including the agent's commission. Also, if your health has declined since you purchased the original policy, it may not make sense to consider a new life policy, since the new premium could be substantially higher.

One of the most important recent trends in the life insurance and annuity world has been the development of "linked" life insurance and annuity policies, which provide that, in the event of a need for long term care benefits, the policy has a provision whereby monies are available tax-free from the policy to pay for long term care expenses.

As an example, one company's single premium fixed annuity policy credits a minimum of 3 percent interest each year to the cash values, but also has a pool of dollars equal to three times the accumulation value available for long term care expenses. This technique is very attractive to mature individuals who may own a fixed annuity, but who have not purchased long term care insurance in the past. By exchanging that old annuity for a linked benefit annuity, dollars are made available for long term care expenses, should the need arise.