Thursday, April 13, 2017

1035in' along

A few months ago, I called out Erie Insurance for what I considered inappropriate activity. Today, I received the final notice from our carrier's Home Office that the plan had, in fact, been surrendered, and the check cut and sent to Erie via 1035 exchange.

That's nice, Henry, but what the heck's a 1035 exchange? An exit off I-75?

No, it's actually a very useful tool we use to avoid excess taxation when trading life insurance polices. And I was quite surprised to find that, 12+ years in, we've never blogged on this.

Allow me to correct that:

First, we need to understand that in permanent life insurance plans (such as Whole or Universal Life), the cash value accumulates with no taxes due. It's called tax-deferred, but not tax-free: the funds accumulate until they're withdrawn, and then one is taxed on the gain over the premiums paid. Turns out, Marcus had paid almost $33,000 in premiums, and the policy value at time of surrender was just north of $87,000. So, he had a gain of about $54,000. If he had just cashed the policy out, and then sent the check over to Erie, he would be on the hook for taxes on that $54,000.

By using a 1035 exchange, and having the original carrier transfer the funds directly to (in this case) Erie, Marcus was saved a major hurtin'. I'm still of the opinion that this was (at best) ill-advised, but at least the gentleman was spared further damage.
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