How to Avoid Financial Pitfalls When Converting Life Insurance Policies to Annuities

Converting whole life or universal life insurance policies into annuities through a 1035 exchange can be a tempting way to defer taxes on investment gains. However, it’s crucial to understand the potential downsides and make informed decisions before proceeding.

ACA Subsidy Loss: A Hidden Trap

One significant consideration is the impact on ACA subsidies. If you receive subsidies to help pay health insurance premiums through the Affordable Care Act, converting your life insurance policy to an annuity could result in a substantial loss of financial assistance. This is because annuities are considered assets, and having too many assets can disqualify you from subsidies or reduce the amount you receive.

For example, if your annuity gains were $90,000, you would face a 25% tax hit due to federal and state taxes in California. Additionally, you could lose $15,000 in ACA subsidies. This can significantly impact your healthcare budget, especially if you rely on subsidies to make your health insurance affordable.

Other Drawbacks to Consider

Annuities may offer some benefits, such as tax deferral and potential growth linked to the S&P 500. However, they also come with several drawbacks:

Fees: Annuities often have annual fees that can eat into your returns over time.
Limited Flexibility: Annuities restrict access to your funds, typically with penalties for early withdrawals.
Surrender Charges: If you need to withdraw your money before the surrender period expires, you may face significant penalties.
Market Risk: Annuities linked to the stock market can fluctuate in value, exposing you to potential losses.

Alternative Options for Tax Deferral

If tax deferral is your primary goal, there are several other options to consider:

401(k) or IRA: These retirement accounts offer tax-deferred growth, and you generally won’t pay taxes until you withdraw funds in retirement.
Health Savings Account (HSA): If you have a high-deductible health plan, you can contribute to an HSA and use the funds tax-free for eligible medical expenses.
Real Estate Investment: Investing in rental properties can provide tax deferral on any gains until you sell the property.

Seek Professional Advice

Making informed decisions about insurance and financial planning is crucial. It’s highly recommended to consult with a licensed insurance agent or financial advisor before converting your life insurance policies to annuities or making any major financial changes. A professional can provide personalized guidance based on your individual circumstances and help you weigh the risks and benefits.