Thursday, July 24, 2014

I Still Think The Life Insurance Company Screwed Them

Originally Published on on August 9th,2011
There have been a few cases in the last year about people getting hosed by taxes when they close down life insurance policies.  The most recent was that of James Ledger but I’m going to skip back to John Sanders, because the numbers were laid out more clearly in that decision.  Mr. Sanders had paid a total of $10,117 in premiums and had borrowed $7,136 on his policy.  When it was cancelled he received a 1099-R showing a gross distribution of $17,292 making him taxable on $7,175.  This happens because the policy loan is clocking interest which is deemed paid when the policy is cancelled.  The interest is non-deductible (or was in the case of Mr. Ledger and Mr. Sanders, anyway).  I asked some insurance guys to comment and I was pleased that my friend Perry Smith got back to me.  I’m sure Mr. Ledger and Mr. Sanders would not have gotten into the pickle they did if they had Perry looking out for them, but he still makes a spirited defense of the the insurance companies.
The deal is actually quite fair – if a person owns an “endowment” – type contract that matures while alive. Most policies written today are NOT endowment life policies – rather, they “mature” when the insured dies, and NOT before at some age or time duration after initial acquisition. 
Think of it this way: If I pay in $50k over 10 years, and take out $70k in loans thereafter – say in year 15, and then surrender the policy in year 20 for a net surrender value of $5k – what have I actually received (ignoring interest)? I have in my pocket received the $75k and my putative basis in the policy is $50k – so I must recognize an ordinary income of $25k. A fair result under current tax law, no? YES. 
HOWEVER, I say that this is almost TOO generous by IRS! Why? Because it does not take into account the fact that there is an annual charge forlife insurance during the term of the policy – a “mortality cost” that is taken from the policy each year by the insurer (you think this is for free?). This “mortality cost” should reduce the taxpayer’s basis in the policy as he/she is receiving a benefit for that “cost” – death benefit insurance coverage for that year! Thus, the above taxable gain calculation truly understates the real economic gain received by ignoring the mortality costs of the policy for the duration of the policy term – something that must be properly calculated in this manner if a loss is to be recognized by a taxpayer when the life policy is taken out for business or investment purposes.  
I do not pity the taxpayer who suddenly is taxable on gains he already put in his pocket years ago – I call that a tax free loan from IRS for the duration of the loan! If the taxpayer was smart, he would retain the policy until his death, and the loan would have never become taxable: The ultimate life insurance benefit!
 Here is the thing about these cases.  The people either didn’t get out more than they put in or the extra they got out was out of proportion to the amount of income that they recognized. I doubt adjusting for the term cost of the policies (mortality charge) would have made an appreciable difference.  The rate charged on the loan is greater than the rate credited to the policy.  Why people pay to borrow their own money is a little beyond me.  There is a sub-branch of micro-economics that deals with that kind of behavior.  I don’t think it is called stupinomics, but it should be.  When the interest charges finally wipe out the policy, there is an asymmetrical result.  The accumulated dividends are taxable but the interest that they are deemed to have paid is not deductible.
I agree with Perry’s overall analysis.  If you want the income tax benefit of life insurance, you need to drop dead.

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