Part 2: Case Studies—Cut Costs and Grow Wealth: Transform Old Life Insurance and Annuities With a 1035 Exchange

November 21 2023

Part 2: Case Studies

In Part 1 of our blog series on the power of Section 1035 exchanges, we explored the technical aspects of how high net worth investors and their advisors can transform legacy life insurance policies and annuities.

Through a 1035 exchange, policyholders can cut costs, access additional investment opportunities, and update policies for their evolving life circumstances.

The 3 case studies below illustrate the process in action and the success sophisticated investors can achieve with a 1035 exchange into private placement life insurance and variable annuities.

29586 CP Blog Post Section 1035 Part 2 Case Studies

Case Study 1: Optimizing the Cash Value of a Whole Life Insurance Policy for Retirement

A. Background:

Meet Alex, a successful architect in his early 60s. Decades ago, when starting a family, Alex purchased a whole life insurance policy. The goal was a lifetime of economic protection for his family. Choosing a whole life policy was intended to secure the financial future for his spouse and kids if anything untoward happened to him. In time, Alex’s two kids grew up to become self-sufficient adults and successful professionals themselves. The policy, originally bought for protection, had served its primary purpose. Over the decades, the policy accumulated a significant cash value. The cash value earned limited annual dividends, and the investment options were limited. Whole life only pays a fixed rate of dividends on the cash value.

B. The Dilemma:

As retirement loomed, Alex’s planning focus shifted. Protecting the family from unforeseen circumstances was no longer the primary concern. The goal now was to fund a long, comfortable, and robust retirement. Alex and his wife looked forward to travelling the world in style and building a home in Wyoming on land they bought years before. As the whole life insurance policy had built up a considerable cash value, the simple route would be to surrender the policy, access the cash, and invest it. However, that would trigger a substantial tax liability, eating into the funds Alex had thoughtfully accumulated over the years.

C. The Solution:

Rather than taking the traditional route, Alex decided to explore a 1035 exchange. With expert advice, Alex discovered the benefits of an exchange of his policy followed by transferring the policy’s value into a new, low-cost private placement variable annuity (PPVA). This strategy would prevent a hefty tax bill, and would also allow Alex to diversify his investments significantly. PPVA offered an array of return-seeking and differentiated alternative investments – opportunities that the old life insurance policy couldn't offer. Alex was able to allocate his PPVA portfolio to a range of high yield private credit strategies and trading-oriented hedge funds. Within a tax-sheltered annuity, Alex could benefit from these differentiated return streams without current taxation.

Alex was also able to adjust the timing of his tax-favored annuity withdrawals to both his needs and for tax planning purposes. He had built up significant tax basis in the old whole life policy, so the initial withdrawals of earnings were not subject to income tax. After that, he planned on timing withdrawals in years when his tax rate was lower. Even better, Alex and his wife were relocating from California, a high tax state, to Wyoming, which has no state income tax.

D. The Outcome:

The 1035 exchange was a seamless transition. His advisor coordinated the transfer of cash values between insurance companies in compliance with tax law. Alex now had a financial instrument that not only catered to his current retirement needs but also offered a sophisticated investment strategy encompassing diversification and potentially significant returns. This access to alternative investments provided a blend of differentiated returns and diversification, helping Alex achieve a retirement that is hopefully as prosperous as the preceding decades.

E. Key Takeaway:

Life's needs evolve, and so should financial strategies. With tools like a 1035 exchange, investors like Alex can adapt their financial portfolios without facing unwarranted tax consequences. Protection once took center stage in Alex's life. Now, prosperity should lead the way. Swapping from whole life policy to a private placement variable annuity contributed to achieving that goal.

Case Study 2: Transforming a Key Person Life Insurance Policy into a Family Legacy

29586 CP Blog Post Section 1035 Part 2 Case Studies 2
A. Background:

Catherine, a dynamic entrepreneur, grew her family-owned furniture manufacturing business. Starting as an apprentice in her grandparents’ small workshop, Catherine modernized and expanded an operation which now employs over 1,000 people.

Recognizing the value of the enterprise and wanting to safeguard the venture along the way, she opted for a key person life insurance policy. This policy was designed to provide the business with financial stability and funding for outside executives if she ever couldn’t contribute, given her pivotal role in the company. As years went by, her business thrived, and the policy accumulated a significant cash value.

When the time was right, Catherine decided to sell the family business. She found a large strategic buyer who could compete internationally and who also agreed to maintain the current operation and employees. Catherine was ready to transition into a life of well-deserved relaxation and family time.

B. The Dilemma:

With the business sold, the key person policy was no longer needed. Yet, the policy held a substantial cash value. As part of the sale, Catherine negotiated for control of the policy. Catherine’s prime concern shifted towards ensuring that her hard-earned wealth would benefit not just her immediate family but the generations to come. The question was: How could she effectively transition this accumulated wealth, including the key person life insurance policy, without significant tax implications?

C. The Solution:

Catherine explored the advantages of a 1035 exchange for the old policy. Guided by tax and estate planning experts, she discovered she could transition the cash value from the key person policy into a Private Placement Life Insurance (PPLI) policy. This move would not only bypass a potential tax hit but also offer her the opportunity to diversify her investments.

The new PPLI policy presented Catherine with a compelling array of alternative strategies, allowing her wealth to compound without incurring current taxation. Best of all, she could name her grandchildren as beneficiaries, ensuring them a legacy.

D. The Outcome:

Through the 1035 exchange, Catherine’s foresight ensured that her wealth was not only protected from immediate taxation but also positioned for growth. The proceeds from her business sale comfortably secured her and her family’s financial future. Simultaneously, the PPLI policy promised a legacy that her grandchildren would benefit from in the years to come.

E. Key Takeaway:

Smart financial transitions, like Catherine's, showcase how entrepreneurial acumen can shine in personal wealth management. Tools like the 1035 exchange provide a pathway to evolve financial strategies, responding to changing life scenarios and ensuring that legacies are built for future generations.

Case Study 3: Educators' Path to Financial Mastery with a Variable Annuity

29586 CP Blog Post Section 1035 Part 2 Case Studies 3
A. Background:

Meet Samuel and Naomi, two dedicated educators with a passion for knowledge. Samuel, a university professor, and Naomi, a school principal, built their careers on the foundation of academic excellence. While their primary focus was on imparting wisdom, they also understood the importance of financial prudence. Early in their careers, they embarked on a journey of disciplined savings, committing funds to a variable annuity with a variety of mutual fund investment options. They had opted out of their schools’ 403(b) savings plans once they discovered the high fees and limitations on withdrawals.

As years passed, their dedication bore fruit in various forms. Not only did their annuity swell due to consistent contributions and decades of growth in the equity markets, but they also accrued substantial pension benefits from their educational institutions. Their prowess wasn’t limited to the classroom. They started an online educational material publications business that blossomed into a thriving operation, generating significant royalties.

B. The Dilemma:

With wealth accumulated from various sources, Samuel and Naomi found themselves at a crossroads. The retail variable annuity they had invested in served them well, but it had its limitations – primarily higher internal costs and limited investment options. Now, in a position of financial strength, the couple aimed to optimize their portfolio, ensuring it was aligned with the best available investment strategies for their multi-faceted investment program.

C. The Solution:

Guided by their innate quest for knowledge and the advice of financial experts, the couple explored the possibilities of a 1035 exchange. They discovered they could transition from their existing retail annuity to a private placement variable annuity. This move would not only reduce their costs but also open doors to a broad spectrum of investment options. The new annuity provided them with access to diversified alternative investment strategies, including private market funds and hedge funds – opportunities previously beyond their reach. The guiding principles of lower costs and investment flexibility once again led to a preferred investment vehicle.

D. The Outcome:

By leveraging a 1035 exchange, Samuel and Naomi successfully transitioned a key component of their savings into a more versatile and cost-effective investment instrument. Their wealth now had the potential to grow with diversified access to a variety of sophisticated investment strategies. Their journey, which began with disciplined savings, had evolved into astute financial planning.

E. Key Takeaway:

Samuel and Naomi's story underscores the importance of continuous learning in personal financial management. Through diligence, dedication, and a desire to optimize, they demonstrated that with the right tools and choices, one can evolve their financial strategies to better suit their growing needs and aspirations.

Next Steps

The case studies above illustrate the diverse applications of Section 1035 exchanges, and how PPLI and PPVA can transform legacy insurance policies and annuities.

To explore how a 1035 exchange may work for you, feel free to connect with us.

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There are technical requirements for a valid 1035 exchange, including new underwriting based on the owner’s health and age. The new policy must also have the same owner and insured person. Any exchange must comply with the insurance licensing and regulatory requirements in the owner’s place of residence.