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Cheap life insurance and 1035 exchange

This is something of a rarity: a tax provision that actually works in your favor. So it is worth knowing what it is and how it can help you. As the title to the article suggests, this is all about Section 1035(a) to (d) of the IRS Code and it allows you to avoid paying tax when you sell an asset. Take the example of shares on which you have made a good profit. You decide you would like to take that profit and reinvest the original capital. So you sell the shares and then discover you have to pay tax on the realized gain. Indeed, almost all rollovers with this purpose will result in a bill from the tax office unless you are exchanging insurance assets. What is wrong with paying tax in this situation? In a capitalist society, the government is supposed to encourage people to invest their money in assets likely to grow in value. If tax interferes with the decisions of when and how many assets to sell, this is an artificial deterrent to commercial decision-making. Indeed, some people may deliberately sell some shares at a loss to set off against gains in other shares. You cannot get more irrational than that when everyone is supposed to be working to maximize their profits.

In this instance, the IRS is encouraging competition between different insurance products by removing the tax incentives from changing one for another. This allows fair competition. So, for example, you may start off with a moderate guaranteed minimum life policy but find competing products are offering a better minimum payout for the same premium payments. More importantly, it allows policyholders to change policies to reflect changes in circumstances. This could be financial problems in the insurer. If the policyholder loses confidence in the insurer and fears it may go into bankruptcy, there should be no penalty to changing. Similarly, if the policyholder is struggling to pay the premium, it should be possible to switch to another insurer who will carry a similar benefit for a lower premium.

Section 1035 allows a transfer between "like-kind" insurance assets. This means you could exchange a health for a life policy, or convert to an annuity or endowment. However, nothing this simple in principle can ever be allowed to remain simple in practice. So you have to get an agreement from the new insurance company to act as your trustee in holding the capital value of your existing assets. The new insurer then writes to the existing insurer to request a transfer of the funds to its possession so that this is a business-to-business transfer and not a cent passes through your hands. You should be warned, some less than responsible insurers can take up to six months to make the transfer.

Because of this, you will probably benefit from talking with an advisor before starting out. A tax consultant can get life insurance quotes for trading down the premium payments and give you a detailed projection of savings and long-term benefits. In this way, you can potentially find cheap life insurance through the transfer market without having to pay any tax on your accrued investment gains. In many cases, even after the consultant's fees, this is a good deal.


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