Replacing a Loan-Laden Whole Life Policy at Age 71
Delores, 71, has owned a $250,000 whole life policy for 12 years. It holds $48,000 of cash value and a $12,000 policy loan at 6% interest that has never been repaid; she has paid $31,000 in premiums over the life of the contract. Her agent, Marcus, wants her to 1035-exchange it into a new $250,000 universal life contract with a target premium of $9,400 a year, a two-year surrender charge schedule, and a fresh two-year contestability and suicide clause. To save time, Marcus marks 'no replacement' on the application, reasoning that UL is a different product from whole life, and tells her the new policy 'has a 10-day free look like any Michigan life policy.' Her health has not changed since she bought the old policy, and no one depends on the death benefit.
1. Marcus says the products are different, so no replacement is occurring. Is he right? Identify the regulatory obligations he has violated and what Delores should have received.
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He is wrong, and the answer is not a labeling question. A replacement occurs whenever new life insurance is bought and existing life insurance is or is likely to be lapsed, surrendered, assigned, or otherwise reduced in value to fund it. The test is what happens to the old coverage, not whether the two products are identical. Whole life into UL is a textbook replacement.
What should have happened:
- A signed Notice Regarding Replacement presented to and left with Delores, not a checkbox marked 'no.'
- A written comparison of the two contracts: premiums, death benefit, guaranteed cash values, surrender charges, the outstanding loan and its compounding interest, and the fact that contestability and the suicide clause start over.
- The insurer must notify the existing insurer, which may furnish its own policy summary, and records of the transaction must be retained for the period Michigan requires.
Marking 'no' on a known replacement is a misrepresentation of a material fact - an unfair trade practice that supports fines, license suspension or revocation, and a rescission claim by Delores. The free look is a weak backstop: by the time she uses it, the old policy may already be gone.
2. Assume Delores proceeds. Do the suitability analysis Marcus should have documented, using the numbers in the fact pattern.
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Costs of the move:
- She gives up $48,000 of accumulated cash value and $31,000 of basis; net equity after the loan is $36,000.
- The $12,000 loan must be repaid out of the transfer or the new contract is issued at roughly $238,000 of death benefit, with unpaid interest capitalizing at 6%.
- New surrender charges and a new two-year contestability and suicide period at age 71.
Benefits of the move: none that the file supports. Her health has not improved, so there is no underwriting gain to justify restarting contestability; she has no dependents, so no need for additional death benefit; and no showing was made that $9,400 of UL premium buys more guaranteed coverage than the existing contract.
Judgment: the exchange is not suitable as presented. A documented needs analysis would compare guaranteed elements (not illustrated ones), note the loss of 12 years of incontestability, and conclude she should keep the policy. If she wanted more coverage, the right answer is to add a second policy and leave the old one intact. The agent also had a conflict: the new premium generates new commission.
3. If she goes forward, what are the federal income tax consequences of (a) surrendering the old policy for cash and (b) completing the 1035 exchange with the loan outstanding?
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(a) Surrender for cash. Cash value $48,000 less basis $31,000 = $17,000 of ordinary income. The loan is treated as a distribution, so the taxable amount is measured against the full $48,000, not the $36,000 she nets after repaying the loan. She is past 59½, so no 10% penalty applies (that penalty reaches only pre-59½ distributions, including from MECs).
(b) 1035 exchange. No gain is recognized if the entire net value moves into the new contract. Because the loan is satisfied out of the transfer, the new contract starts at about $36,000 of value while the $31,000 of basis carries over. A loan creates taxable income only to the extent it exceeds basis - $12,000 is well below $31,000, so nothing is currently taxable. If she had instead taken cash out to repay the loan herself, that cash would be taxable to the extent of gain.
Watch the MEC trap: a heavily funded UL or a policy with too much premium relative to the death benefit becomes a modified endowment contract, and later loans and withdrawals then come out gain-first with possible penalties.