Hefty tax bills could lurk in failed life insurance policies

The failure of a life insurance policy is bad enough. But the situation instantly goes from bad to worse if there are loans against the policy — a hefty tax bill could be waiting in the wings.
In-force life insurance policies of all varieties that were written during the 1980s and 1990s are facing pressure due to current low interest rates. The problem lies in the fact that the policies were written with optimistic interest rate assumptions. For universal life policies, clients expected to receive an attractive credited interest rate on their cash value — a rate high enough that would sufficiently cover the policy’s costs. For whole life policies, dividends credited to the cash value were expected to foot expenses.
Today’s low rates make it hard for insurers to continue being so generous, so clients now are expected to chip in even more money to foot the bill for keeping the policy in force — or else surrender the policy. Alternatively, clients can cut death benefits or try to sell the policy to a buyer on the secondary market.
Life insurance experts warn that another threat looms with failed policies: Should the client surrender the insurance coverage or let it lapse, and there are loans against the cash value, they could face a giant tax bill for so-called “phantom income.”
Many insurance policies will default to an automatic payment schedule if the client stops paying the premiums. In this case, the costs will be deducted from the cash value, and those deductions are considered an internal loan.
“It collapses these policies from the inside out; there are sometimes seven- or eight-figure loans on these policies,” said Bill Boersma, president of Opportunity Concepts, a life insurance consulting firm. “The worst that can happen is that you lose the policy and you are in debt to the IRS.”
So-called phantom income in the context of a life insurance policy can be triggered in two ways.
In the event of a surrender, phantom income is the gross distribution the insurer pays to the client at surrender minus the amount the client invested into the contract. The difference left over is considered taxable income. This amount is also called “phantom income” because if the client has outstanding loans (and interest) against the cash value, the gross distribution will go toward repayment of that loan. As such, a client who has large loans against a policy could receive a very small check from the insurer at surrender — but still face a very large income tax bill.
In case of a lapse, where the client just stops paying premiums, the phantom income is the difference between the policy loan and the premiums paid into the policy: A $100,000 loan minus $80,000 in past premiums paid equates to $20,000 of taxable income.
For example, the U.S. Tax Court on Dec. 2 found a New York couple liable for income taxes on $33,125 from a surrender of a life insurance contract. The husband sought to surrender a life insurance policy in 2010, some 26 years after purchasing it, when he and his wife became unable to pay premiums. There were loans against the cash value. The issuing insurer made a gross distribution of $65,903 when the policy was surrendered, of which the husband’s investment in the contract was $32,778 — but the couple received a check for only $3,786, the net value of the policy after repayment of outstanding loans. The couple still wound up on the hook for $33,125 in taxable income.
There are few ways out of this scenario once a client lapses or surrenders the policy and winds up holding the taxable-income bag.
One possibility is to negotiate a deal with the insurance company to reduce the face amount of the policy so that the policy costs less to maintain, according to Peter Katt, a fee-only life insurance adviser at Katt & Co. The odds are relatively slim, however, and much rides on whether the insurer is willing to make the adjustment. “In the last five or six cases I’ve had, two or three insurers have been cooperative,” Mr. Katt said. “I’ve seen people get hit with $200,000 to $300,000 in phantom income.”
“When you surrender or change the policy, that’s when the loans become a problem,” said Thomas J. Henske, a partner with Lenox Advisors Inc. “If the client died, [the additional income taxes] wouldn’t be a problem.”
The moral, Mr. Henske said, is to review life insurance policies on a regular basis, but also to make sure that if the client is considering surrendering or letting the policy lapse — or exchanging it for another — to ask the insurer for a quote on what the taxable income would be.
“It comes back to policy monitoring,” said E. Randolph Whitelaw, founder of the TOLI Center. ”Most people don’t understand how life insurance works. If they have loans, they have a problem.”

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