Life & Health Insurance/tax liabilities Endowment Insurance Policy
Dear Mr. Brambaugh, This is an inquiry about an Endowment Insurance Contract with an outstanding loan that was not repaid and has accumulated interest that has exceeded the policy value. In 1987, my mother brought four identical single premium endowment insurance contracts, each w/ the premium of $10,000. She was owner and beneficiary. Each of her four daughters were the insured. In 1991, the agent advised her to borrow from the policies to provide cash for each daughter's family expenses. The amount of the loans was perhaps $50,000 total. It was never repaid and has been accumulating interest ever since. The agent possessed all record and information that was never made available to my mother as owner or her daughters as insured. My mother established an irrevocable trust in 1993 and her assets were transferred to that trust. She died in 2002 and the proceeds of her trust "poured over" or were transferred by trustees into a family trust. Now, after over 22 years, the amount of the insurance policy loans plus accumulated interest has exceeded any value of the policies and amounts to almost $250,000. I have now learned of this situation and that the policies were going to lapse so the trustee put another $20,000 into the policies to keep them alive. Is there any way to avoid a huge tax bill? The original policy lists each of her daughters as contingent owners, but the trustee interpreted the policies as assets of my mother, the policy owner, and that the policies should pass into her trust and then the family trust. The trust is now the owner of record for each of the four policies. The trust tax rate is 28% as is the four daughters, is there any way to avoid what seems to be an enormous tax bill? I have tried to research this topic and have found that the insurance policy is probably not a MEC since it was issued in 1987 and that the Section 7702 of the IRC probably governs situations like this one. Any clarification would be gratefully received.
The trustee has taken the best step for resolving the problem.
Judging by what you have told me, these are Participating Whole Life policies with endowment dates short of life expectancy. These are practical when properly administered. However, it appears that insufficient counseling was provided by the agent that recommended the loans.
Without knowing the company and policy type these are, my opinion is conjecture. However, assuming these are with one or more of the traditional Par companies, it would be worthwhile to rehabilitate the policies for retirement purposes. If you and your sisters have IRAs, there is a provision in the IRC that would allow transferring funds into the policies without the usual Premature Distribution Penalty. I would be happy to explain how this works.
Assuming my forty-six years experience has adequately prepared me to answer your question, I believe that were you to do as I suggest, the four of you would do best by focusing on these policies for retirement, rather than new contributions to IRAs. I am eager to learn more about your situation. Please contact me at (888) 792-2379 or firstname.lastname@example.org.
The section of the Internal Revenue Code to which I refer is 72(t). The following is an excerpt from my report, 'Life Insurance and Retirement - the Unvarnished Truth':
Section 72(t) of the Internal Revenue Code provides IRA participants the opportunity to move funds out of their IRAs at any time prior to age 59 ˝, subject to only income taxes. The Premature Distribution Penalty does not apply. There are three ways to fulfill the spirit of the regulation. The first is to convert the IRA into an immediate level periodic income for the rest of your life. This is called Annuitization. There might be a time when this is a good choice, but not times like now, while interest rates are so low. Negatives with this option are loss of control of the asset and an unchangeable periodic payment that ends with the death of the beneficiary of the annuity, even if that happens one month after initiating the income distributions.
The second option is to annually divide the year-end balance by the owner’s life expectancy, as defined by the Single Life Expectancy Table in IRS Publication 590, Appendix C. Assuming the IRA owner is age 40, he would divide the IRA value by 43.6. If that were $200,000 the first year would be $4,587.16. The next year the new balance would be divided by 42.7. Each year the new balance would be divided by a shorter life expectancy. The remaining account value is accessible, but the annual distributions are inconveniently small at the start and rigidly driven by the Federal life expectancy table.
The third option requires a level distribution through age 59 ˝ and a minimum of five years. Once these requirements have been fulfilled, the IRA owner is free to change the rate of withdrawals. The amount of each distribution is determined by the life expectancy table in IRS Publication 590 and the current Applicable Federal Rate – Midterm Table. In this case, applying the same age and principal, in August 2013, the annual distribution would be $6,728.38.
Using the above strategy, for most people, will result in the availability of an un-taxed (and unreported) income stream at retirement. This can be done by taking annual distributions as loans. By maintaining value in the policy sufficient enough to keep the policies in force, more-than-bank cash-flow is projected while continuing to provide a life insurance benefit to the beneficiaries at the time of the insureds' demise.
Willard R. Brumbaugh, LUTCF
CA License 0374776