Variable Insurance Products and Changing Capital-Gains Rules

It is increasingly likely that we will see a significant increase in capital-gains income tax rates if the Obama administration gets its proposed changes to the tax laws. When this happens, the advantages of variable insurance products become even more important than they are with current capital-gains tax rates. It has long been recognized that most variable insurance products offer a large variety of investment options from among the underlying investments. They are also uniquely suited for asset allocation programs. A less-recognized feature of these products is the ability to switch underlying investments without recognition of gain for purposes of the federal and state income taxes.

Both variable annuities and variable life insurance have long offered an almost staggering choice of investment options to underlie the products. Over the years in which we have been consulting variable insurance products we have seen everything from commodities to brick-and-mortar real estate as permissible options to underlie variable products. Most variable insurance products permit frequent (in some cases, unlimited) changes in investment orientation to enable owners of the products and their advisors wide latitude in responding to changes in economic conditions and in the marketplace. This investment flexibility is one of the hallmarks of variable insurance contracts.

In recent years, the decrease in rates of capital gains taxes have reduced the value of one of the principal features of variable insurance products--the ability to switch underlying investments without recognition of gain for the purposes of capital gains taxes. This lack of a requirement to recognize gains for tax purposes applies not only to "long-term" capital gains, but also to "short-term" ones and has caused a marked increase in the availability of investments to underlie variable insurance products that are more likely to give rise to short-term capital gains. Thus, we have seen various types of hedge funds, commodity pools and similar, more-volatile, investments become available to underlie variable insurance products. With the return of higher tax rates on long-term capital gains, more mainstream types of investments will have a greater appeal to use with variable insurance products.

It is also important to recognize the advantages inherent in variable insurance products with respect to the ability to make tax-free exchanges of a variable annuity for another fixed or variable annuity or a variable life insurance policy for another variable life insurance policy or for a fixed or variable annuity--all without recognition of gain for tax purposes. These tax-free exchanges are often referred to as "1035 exchanges" because they are permitted by Section 1035 of the Internal Revenue Code.

We are never in favor of exchanges of existing variable insurance products (or of fixed products, for that matter) unless there is a valid reason for doing so. Valid reasons include exchanges to obtain new product features, lower prices, better guarantees, or investment options that may not be available in the products that are currently owned by the contract owner or policy owner. Exchanges of an insurance product often results in new surrender charges or sales charges or of higher contract fees. Therefore, a cost/benefit analysis is always warranted and is required under applicable laws and regulations of both federal and state governments. Nevertheless, the fact that a contract owner or policy owner is never "locked in" to a product that may no longer be appropriate or that may be obsolete is one of the advantages of purchasing annuities and life insurance.

Any change in investment orientation under a variable insurance product or of an exchange of one product for another must be accomplished with strict adherence to the applicable rules. Changes in underlying investments under a variable annuity or variable life insurance policy are fairly routine and generally quite safe insofar as tax compliance is concerned. All the owner of the product needs to do is to comply with the requirements of the insurer that issued the product. The only possible pitfall is the issue of "policy owner control" that has been enunciated by the Internal Revenue Service. Although the concept of "policy owner control" has never been formally adopted into the Internal Revenue Code, the IRS maintains the position that if a policy owner has too much say over the investments underlying a variable insurance product that such an amount of control is inconsistent with ownership of the assets by the insurer. The result is that investment income will be currently taxed to the policyowner instead of being deferred until the policy is surrendered or withdrawals are made. The vast majority of variable insurance products offered on the retail market today are very unlikely to have any problems with "policy owner control."

1035 exchanges are another matter. Although the IRS has eased some of the technical requirements for a successful 1035 exchange in recent years, it is essential that any such exchange comply with the rules necessary to avoid the application of the doctrine of "constructive receipt." This doctrine is long-standing in federal income tax law and simply stated says that if you have the unfettered right to obtain taxable income you are constructively presumed to have done so. Section 1035 of the Internal Revenue Code provides for a tax-free exchange of one insurance product for another. Therefore, there must, in fact, be such an exchange. This does not mean surrender and repurchase. The safest bet is to do the exchange though the new issuing insurer rather than to attempt surrender and repurchase. Virtually all insurers have procedures in place to assist policyowners in accomplishing 1035 exchanges.

Investment flexibility is one of the hallmarks of variable insurance products and will probably assume increased importance as the inevitable increases in taxes affects us all.