Dr. John Jones fell into the life insurance policy loan trap. A successful dentist, Dr. Jones purchased a life insurance policy from ACME Mutual Life Insurance Company. For the first six and a half years, he paid the insurance premiums by check. For the next 15 1/2 years, he paid the premiums by borrowing at 8 percent interest against the policy’s cash value. Because of the borrowing, the Year 22 annual interest accrual was twice the insurance premium due. This was a problem.
But a bigger problem was that ACME could terminate the policy if the policy debt exceeded the cash surrender value. To mitigate this problem, Dr. Jones surrendered his $310,063.30 of additional paid-up insurance that he had earned over the 21 previous years by investing his ACME policy dividends to buy additional paid-up insurance.
Unfortunately, his surrender of the additional paid-up insurance did not cure Dr. Jones’s problem. The surrender simply reduced both the policy debt and the cash value of the policy. Thus, after the surrender, Dr. Jones continued to have policy debt in excess of the cash surrender value. At the end of year 24, ACME terminated the policy because the policy debt exceeded the cash surrender value, and Dr. Jones’s tax nightmare began.
ACME sent Dr. Jones a Form 1099-R that described $373,650.06 as loans repaid at surrender and reported $290,930.30 as the taxable amount at surrender.
Dr. Jones and his wife believed that they received the 1099-R in error, and they did not report the $290,930.30 as taxable income. Not reporting 1099 income is a mistake. It drives the IRS computers nuts because they cannot match the 1099 to the tax return.
The IRS assessed the tax that would have been due had the $290,930.30 been included in the tax return. The Jones’s disputed the tax and took their case to court, where they lost and also were tagged with a 20 percent penalty for substantial understatement of taxes.
The Full Story
Many taxpayers borrow against their life insurance cash surrender values. In fact, a common strategy is to borrow cash value during your lifetime and then have the insurance company offset the death benefit by the outstanding loan amount when you die.
But when a life insurance policy terminates before death, the cash surrender value is taxable and the Grim Reaper is looking for tax dollars. In this case, ACME did not send any cash to the Jones’s because the entire cash surrender value was needed to pay off the loans. In the days of tax shelters, the receipt of taxable income without the receipt of cash was called “phantom income.”
As noted by the court, here is how the ACME policy worked in the Jones’s case:
Monies Earned by the Policy:
Surrender value at termination used to pay loans $373,650.06
Surrender value from paid-up insurance used to pay loans $310,633.00
Dividend payment to Dr. Jones $29,869.40
Dividend payment to Dr. Jones $18,830.00
Total monies earned and paid out to Dr. Jones $732,983.00
Monies Invested in the Policy
Policy premiums paid by loans $285,320.00
Policy premiums paid by checks $119,990.00
Policy premiums paid by applying dividends to premiums $36,740.00
Total Investment in Policy $442,050.00
Taxable Income at Termination $290,930.30
*Note that most of the action on this life insurance policy took place inside the policy itself. Dr. Jones saw less cash.
Take a look at the cash values in your insurance policies, including those that cover your children. Are you using cash values to pay the premiums?
If so, are you creating a tax liability upon the termination of the policy? If yes, is it possible that the insurance company will terminate your policy and trigger taxable income to you? If so, start your tax planning now to offset this taxable income or put aside the money you need to pay the taxes.