Tax Reduction Strategies Using Investments or Life Insurance

Common Investment Strategies to Reduce Taxes

If you are investing in mutual funds, then tax free bonds and index funds are going to produce the least taxable income. In the case of municipal tax-free bond funds, dividends are not taxable for federal income taxes and possibly state taxes, and only capital gains from the sale or appreciation of the underlying bonds are taxable.

Securities are also considered capital assets by the IRS and as such can receive favorable tax treatment on long term capital gains generated by these investments.

Investment in the right kind of tax-free bond funds may result in savings on both state and federal income taxes. Index funds typically produce less taxable income due to a low turnover in the stock holdings and resulting low capital gains earnings.

Individuals who own property that has high deferred capital gains, have several tax strategies available. One is a tax-free exchange to a new similar property. Another very common strategy for older investors is to give the property to a charitable organization using a charitable remainder trust and avoid most taxes altogether. There are several strategies that can be used based on charitable gifting.

The most popular vehicle for reducing estate taxes is a trust designed for that purpose. There are also gifting strategies along the way to reduce the size of the estate.

There are myriad trust arrangements to transfer assets to the next generation and reduce such taxes as generation skipping taxes and other potential taxes. Some planners use partnerships to transfer assets. Other planners might use arrangements with life interests.

Life insurance is useful as a tax planning tool because the death benefit is tax free. If an asset that has a healthy tax bite in it can be leveraged through life insurance to a tax-free asset of equivalent or greater value, such a strategy should be pursued.

Tax-Free Exchange of Insurance Products

IRS publication 575
Tax-free exchange. No gain or loss is recognized on an exchange of an annuity contract for another annuity contract if the insured or annuitant remains the same. However, if an annuity contract is exchanged for a life insurance or endowment contract, any gain due to interest accumulated on the contract is ordinary income.

If you transfer a full or partial interest in a tax-sheltered annuity that is not subject to restrictions on early distributions to another tax-sheltered annuity, the transfer qualifies for nonrecognition of gain or loss.

If you exchange an annuity contract issued by a life insurance company that is subject to a rehabilitation, conservatorship, or similar state proceeding for an annuity contract issued by another life insurance company, the exchange qualifies for nonrecognition of gain or loss. The exchange is tax free even if the new contract is funded by two or more payments from the old annuity contract. This also applies to an exchange of a life insurance contract for a life insurance, endowment, annuity, or a qualified long-term care insurance contract.

If you transfer part of the cash surrender value of an existing annuity contract for a new annuity contract issued by another insurance company, the transfer qualifies for nonrecognition of gain or loss. The funds must be transferred directly between the insurance companies. Your investment in the original contract immediately before the exchange is allocated between the contracts based on the percentage of the cash surrender value allocated to each contract.

Example
You own an annuity contract issued by ABC Insurance. You assign 60% of the cash surrender value of that contract to DEF Insurance to purchase an annuity contract. The funds are transferred directly between the insurance companies. You do not recognize any gain or loss on the transaction. After the exchange, your investment in the new contract is equal to 60% of your investment in the old contract immediately before the exchange. Your investment in the old contract is equal to 40% of your original investment in that contract.

Tax-free transfers for certain cash distributions. If you receive cash from the surrender of one contract and invest the cash in another contract, you generally do not have a tax-free transfer. However, you can elect to receive tax-free treatment for a cash distribution from an insurance company that is subject to a rehabilitation, conservatorship, insolvency, or similar state proceeding if all of the following conditions are met.

• You withdraw all the cash to which you are entitled.
• You reinvest the proceeds within 60 days in a single contract issued by another insurance company.
• You assign all rights to any future distributions to the new issuer if the cash distribution is restricted by the state proceeding to an amount that is less than required for full settlement.
• An exchange of these contracts would otherwise qualify as a tax-free transfer.

You must give the new issuer a statement containing the following information.

• The amount of cash distributed under the old contract.
• The amount of cash reinvested in the new contract.
• Your investment in the old contract on the date of the initial distribution.

You must also attach the following items to your timely filed income tax return for the year of the initial distribution.

• A copy of the statement you gave to the new issuer.
• A statement that contains the words "ELECTION UNDER REV. PROC. 92-44," the new issuer's name, and the policy number or similar identifying information for the new contract.

Tax-free exchange reported on Form 1099-R. If you make a tax-free exchange of an annuity contract for another annuity contract issued by a different company, the exchange will be shown on Form 1099-R with a code "6" in box 7. You need not report this on your tax return.

Date of purchase of contract received in a tax-free exchange. If you acquire an annuity contract in a tax-free exchange for another annuity contract, its date of purchase is the date you purchased the annuity you exchanged. This rule applies for determining if the annuity qualifies for exemption from the tax on early distributions as an immediate annuity.