After dealing with great amounts of frustration and an inability to arrive at concensus regarding a critical accounting question, I've decided to move ahead and cash in my insurance policies with cash value.
As I've mentioned before, the majority of policies are variable insurance policies with mutual fund sub-accounts. Obviously not the most inexpensive funds at that. There is also a small whole life policy.
The great question was this:
If one of the policies with a cost basis of over $50k, has a cash value of $35k due to insurance and surrender charges, can I do a 1035 exchange into a low cost variable annuity. Let the new, better mutual funds grow until the $15k net loss is eliminated and then cash out the annuity with zero capital gains / taxable income.
My CPA and my friend's CPA have both insisted we will pay a 10% penalty for cashing out an annuity before the age of 59 1/2. The 10% penalty would erase most of the capital gains offset benefits. The insurance people I talked with disagreed - but it's the CPAs who have to sign off on my tax return. This one went to the CPAs, though I'm not happy with it.
I contacted the insurance companies and learned that if I cashed in all the policies, they would report about $1500 in gains, which are reported on a 1099 form as ordinary income. I'll owe about $600. Also, I'll lose the hypothetical, but unproven, capital loss.
In the end, I'll have about $70,000 in cash, freed from the expensive and opaque constraints of the variable and whole life policies.
My plans are to put the money in low cost balanced index funds at Vanguard until I resume investment planning with my investment advisor Summer 2007.
Even if the investments perform the same as within the variable insurance policies (which I doubt), the mutual fund fees will probably drop from 1.x% to 0.2 - 0.5%. Possibly a drop of more than 1% in expenses - huge difference over the next 30 years!
Most importantly, I'll be able to integrate the funds into my overall portfolio allocation strategy and rebalance as needed - though judiciously as they will be in a taxable account.