Walter Wants Out: Loan, Basis, and a Replacement Decision
Walter, 68, retires in March and wants to stop paying the $7,400 annual premium on the whole life policy he bought in 1998. It is not a modified endowment contract. Current figures: $310,000 death benefit, $96,000 gross cash value, a $38,000 policy loan at 7% with interest added to the loan balance, and a $61,000 cost basis (premiums plus dividends applied to paid-up additions). Dividends of about $2,200 a year have been buying paid-up additions. His wife Carol is 66 and healthy; their only other significant liquid asset is $140,000 in a 401(k). His stated goals: "stop the bleeding, get something out of it now, and don't leave Carol with a mess." A friend has suggested a 1035 exchange into a fixed indexed annuity with an 8% premium bonus and a 10-year surrender schedule.
1. If Walter surrenders the policy outright, what is the tax result? Show the arithmetic and explain the element that is not visible on the surrender check.
Read the worked answer
The gain is measured on amounts received, and the loan counts as an amount received.
- Gross cash value: $96,000
- Less cost basis: $61,000
- Taxable ordinary income: $35,000
The surrender check Walter receives will be roughly $58,000 ($96,000 less the $38,000 loan and accrued interest), so he will file on $35,000 of phantom gain even though he never received it. Forgiving the loan is a deemed distribution under the contract, not a tax-free event. Accrued interest added to the loan also increases the amount realized and the taxable gain.
Because this is life insurance rather than an annuity or a MEC, the 10% early-distribution penalty does not apply.
Practical point: at, say, a 24% marginal rate the surrender costs about $8,400 of tax. That figure has to be charged against the liquidity benefit before comparing it to a premium stop or an exchange.
2. Compare reduced paid-up, extended term, and the proposed 1035 exchange against Walter's three stated goals. What do you recommend, and what are the two biggest risks in your recommendation?
Read the worked answer
Reduced paid-up: the net cash value (after extinguishing the loan) buys a smaller permanent policy, no further premiums, and a death benefit that lasts for Carol's lifetime. It directly serves "no more premium" and "don't leave Carol with a mess." Cost: the death benefit drops sharply at age 68, and the loan must be settled out of the value rather than left to compound at 7%.
Extended term: keeps the full face for a fixed number of years with no premium, but converts a permanent asset into a wasting one. It fails the "don't leave Carol with a mess" goal unless the term period comfortably exceeds life expectancy.
The 1035 exchange: preserves basis, defers the $35,000, but the 8% bonus is generally priced into a longer surrender schedule and higher internal charges. A 10-year surrender period at 68 is a liquidity trap, gains come out as ordinary income (no step-up at death), and an annuity gives Carol a lump sum rather than leveraged death benefit.
Recommendation: reduced paid-up with the loan cleared, using $38,000 of the $96,000 cash value to do it. It ends the premium, removes a compounding 7% loan, and keeps tax-free life insurance in force.
Risks: (1) the paid-up death benefit may be inadequate - quantify the gap and consider a small separate term policy or an infusion from the 401(k); (2) Walter loses access to the cash value he wanted "out now" - confirm his real liquidity need before locking it up.
3. If Walter insists on the 1035 exchange anyway, what are your professional obligations in placing it?
Read the worked answer
The exchange is a replacement of existing life insurance, so the state replacement regulation applies even though the new product is an annuity:
- Deliver and review the required replacement notice and a side-by-side comparison; give the existing insurer the required notice so it can contact Walter.
- Know the surrender-charge schedule, the indexed crediting method, caps and participation rates, the income rider charge, and any market value adjustment. Disclose your compensation on the new contract.
- Do not sign a replacement notice that misstates the transaction, and do not accept a "not a replacement" box on the form when a life policy is being surrendered.
- Confirm the state free-look period, which is often longer on replacements.
- Document the file: the alternatives presented, Walter's reasons, and his acknowledgment that he is giving up a $310,000 tax-free death benefit for an asset taxed as ordinary income to his beneficiaries.
The governing standard is suitability/best interest for the client, not the size of the commission. If your file cannot show why the exchange is better for Walter than reduced paid-up, the right answer is to decline the case.