Mechanics of 1035 Exchange out of Whole Life - Directions Needed

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Nearly A Moose
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Mechanics of 1035 Exchange out of Whole Life - Directions Needed

Post by Nearly A Moose » Fri Oct 06, 2017 1:08 pm

I'm likely going to be getting out of a whole life insurance policy. From what I've read here and at the White Coat Investor, it seems like a 1035 exchange into a Vanguard annuity may be my best way out. I'm looking for a step-by-step set of instructions on how I'd do this to make sure I understand all the moving pieces. I've seen lots of posts on the steps for Backdoor Roths, but I can't find one for 1035 exchanges. I'm hoping someone could post one here.

My understanding is that I would have two options: (1) exchange the whole life policy into an annuity, let the annuity grow until the cash value meets my basis, and then cash it out with zero tax consequences, or (2) exchange the whole life policy into an annuity, then relatively quickly cash out the annuity and realize a loss that can be applied on my tax return. (I don't think I have a need for annuity long-term right now.) I'm looking for something like "Call you insurance company, tell them X, then call Vanguard and do Y, then file tax from Z..." I'd also like a suggestion on which annuity is right for options 1 or 2. And if I were to take Option 2, is the loss taken against ordinary income or capital gains? My state+federal marginal rate is nearly 50%, so a deduction against ordinary income is quite appealing.

The policy (Mass Mutual Legacy 100) has a cash value of $25,490.89, with $36,000 paid in. I can't find any additional surrender values or fees in my paperwork. No loans have been taken against the policy. My next annual premium is due Feb. 2018. I would put an appropriate amount of level term insurance in place first. Full details on the policy are in this post over here if anyone needs them: viewtopic.php?t=228714.

Thanks so much
Moose
Pardon typos, I'm probably using my fat thumbs on a tiny phone.

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friar1610
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Re: Mechanics of 1035 Exchange out of Whole Life - Directions Needed

Post by friar1610 » Fri Oct 06, 2017 5:01 pm

Nearly A Moose wrote:
Fri Oct 06, 2017 1:08 pm
I'm likely going to be getting out of a whole life insurance policy. From what I've read here and at the White Coat Investor, it seems like a 1035 exchange into a Vanguard annuity may be my best way out. I'm looking for a step-by-step set of instructions on how I'd do this to make sure I understand all the moving pieces. I've seen lots of posts on the steps for Backdoor Roths, but I can't find one for 1035 exchanges. I'm hoping someone could post one here.

My understanding is that I would have two options: (1) exchange the whole life policy into an annuity, let the annuity grow until the cash value meets my basis, and then cash it out with zero tax consequences, or (2) exchange the whole life policy into an annuity, then relatively quickly cash out the annuity and realize a loss that can be applied on my tax return. (I don't think I have a need for annuity long-term right now.) I'm looking for something like "Call you insurance company, tell them X, then call Vanguard and do Y, then file tax from Z..." I'd also like a suggestion on which annuity is right for options 1 or 2. And if I were to take Option 2, is the loss taken against ordinary income or capital gains? My state+federal marginal rate is nearly 50%, so a deduction against ordinary income is quite appealing.

The policy (Mass Mutual Legacy 100) has a cash value of $25,490.89, with $36,000 paid in. I can't find any additional surrender values or fees in my paperwork. No loans have been taken against the policy. My next annual premium is due Feb. 2018. I would put an appropriate amount of level term insurance in place first. Full details on the policy are in this post over here if anyone needs them: viewtopic.php?t=228714.

Thanks so much
Moose
There's a couple of things above that just don't sound right to me.

1. If you do a 1035 exchange from a whole life policy to a VA, aren't you simply transferring the cash value? I'm not sure that what you've paid in has any relevance here. The advantage in transferring the cash value under a 1035 is that you avoid the tax you would pay on the cash value if you simply surrendered the policy for the cash value. Then that amount becomes the basis of the VA.
2. I don't think you can realize a capital loss within a VA since it's a tax-deferred account.

Others probably know more than I do about this. But I have a Vanguard VA (not bought via a 1035). Several years ago I looked into transferring the cash value of a whole life policy into the VVA via a 1035. I decided against it but at the time at least got a passing familiarity with some of the implications, leading to my conclusions above. But if I'm wrong I'm sure another more knowledgeable BH will weigh in.
Friar1610

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grabiner
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Re: Mechanics of 1035 Exchange out of Whole Life - Directions Needed

Post by grabiner » Fri Oct 06, 2017 6:15 pm

friar1610 wrote:
Fri Oct 06, 2017 5:01 pm
1. If you do a 1035 exchange from a whole life policy to a VA, aren't you simply transferring the cash value? I'm not sure that what you've paid in has any relevance here. The advantage in transferring the cash value under a 1035 is that you avoid the tax you would pay on the cash value if you simply surrendered the policy for the cash value. Then that amount becomes the basis of the VA.
What you have paid in is relevant for tax purposes, because you only pay tax on your gain; the amount you paid in has already been taxed and will not be taxed a second time. If you have a net gain, the 1035 exchange allows you to defer tax on the proceeds. If you have a net loss, the 1035 exchange means that you keep your old basis, and thus you pay no tax on gains in the new fund until you have made up the loss; you can then cash in the new VA with no tax penalty and invest in something else if appropriate.
David Grabiner

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Re: Mechanics of 1035 Exchange out of Whole Life - Directions Needed

Post by Nearly A Moose » Tue Oct 10, 2017 8:55 am

Taking the liberty of bumping my post one time. Would love to hear any further input on the mechanics. I've seen this recommended a lot as a way to get out of a WL policy, but much less on follow through. I've had one expensive financial lesson in the process, don't really want another...

Thanks
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ofckrupke
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Re: Mechanics of 1035 Exchange out of Whole Life - Directions Needed

Post by ofckrupke » Tue Oct 10, 2017 9:30 am

Download the VA prospectus/application packet from Vanguard and attend to the pages of the application.
You will infer that the stages of back-channel transfer of your contract interest from the WL provider to the newly established VA with Vanguard's insurance company partner will not likely be visible to you, let alone be under your control to expedite or halt. I believe it will take at least a couple of months to complete, once started. As with with the forced extraction of brokerage assets from broker A to B under orders/power of agent you submit to B, the industry has decided that it serves neither provider for you to witness the cycles of prevarication and escalating threat...the 1035 exchange is an industry sausage, at least one aspect of whose assembly it's been decided you should not watch. Of course it shouldn't be this hard since A is shedding a liability as well as assets, but whatever.

But if your intent is to add some term to replace the WL and would not do the exchange if that is not an option, you probably want to apply for the term and at least get past the underwriting stage before initiating the 1035 exchange. You may end up buying a few months of double coverage because you can't coordinate the timing as precisely as we'd like in the 21st or even 20th century...but this is largely an industry from an earlier time.

Anyway, it's lemonade you're shooting for, not a silk purse.

michaelj
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Re: Mechanics of 1035 Exchange out of Whole Life - Directions Needed

Post by michaelj » Tue Oct 10, 2017 11:19 am

I just did this earlier this year.
  1. Call Mass Mutual and verify you don't have any surrender charges. How long have you held the policy?
  2. If you have a continued need for life insurance, get an appropriate term policy in place first. While you are waiting for this, you may want to suspend your premium payment.
  3. Go https://personal.vanguard.com/us/Litera ... yPoint=SVC to get the Vanguard VA application. Make sure you get the one for your state.
  4. Give the Vanguard VA group a call at 800-357-4720. They will walk you through the application and help you fill it out correctly.
  5. Submit the form to Vanguard. They will take care of contacting your insurance company and doing the transfer of money
  6. The initial transfer could take a couple of weeks to complete. Be aware that when it first comes over to Vanguard, the cost basis may show as $0. That freaked me out as the whole purpose of doing this was to preserve the cost basis for tax purposes. When I talked to Vanguard about this, they told me that the cost basis would come over shortly from my insurance company and it did.
  7. Once the cost basis shows up, you can surrender the VA if that is what you choose to do or as you stated let it grow tax free back to your cost basis. Just be aware that the fees on the VA funds are higher than normal Vanguard funds.
  8. If you surrender the VA, then you get to decide how aggressive you want to be with the loss on your tax return.
The whole process wasn't that bad. Vanguard was really helpful in reviewing the application to make sure I had everything filled out correctly. They will make sure you get it right.

Good luck!

- Mike J

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Re: Mechanics of 1035 Exchange out of Whole Life - Directions Needed

Post by Nearly A Moose » Tue Oct 10, 2017 1:37 pm

michaelj wrote:
Tue Oct 10, 2017 11:19 am
I just did this earlier this year.
  1. Call Mass Mutual and verify you don't have any surrender charges. How long have you held the policy?
  2. If you have a continued need for life insurance, get an appropriate term policy in place first. While you are waiting for this, you may want to suspend your premium payment.
  3. Go https://personal.vanguard.com/us/Litera ... yPoint=SVC to get the Vanguard VA application. Make sure you get the one for your state.
  4. Give the Vanguard VA group a call at 800-357-4720. They will walk you through the application and help you fill it out correctly.
  5. Submit the form to Vanguard. They will take care of contacting your insurance company and doing the transfer of money
  6. The initial transfer could take a couple of weeks to complete. Be aware that when it first comes over to Vanguard, the cost basis may show as $0. That freaked me out as the whole purpose of doing this was to preserve the cost basis for tax purposes. When I talked to Vanguard about this, they told me that the cost basis would come over shortly from my insurance company and it did.
  7. Once the cost basis shows up, you can surrender the VA if that is what you choose to do or as you stated let it grow tax free back to your cost basis. Just be aware that the fees on the VA funds are higher than normal Vanguard funds.
  8. If you surrender the VA, then you get to decide how aggressive you want to be with the loss on your tax return.
The whole process wasn't that bad. Vanguard was really helpful in reviewing the application to make sure I had everything filled out correctly. They will make sure you get it right.

Good luck!

- Mike J
Perfect - exactly what I needed, thanks so much!
Pardon typos, I'm probably using my fat thumbs on a tiny phone.

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