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Swapping one policy for another: California's replacement rules

If a new term policy will take the place of one you own, California adds consumer protections. Under Insurance Code 10509.2, buying new coverage is a replacement when the agent or insurer knows or should know the existing policy will be lapsed, surrendered or otherwise terminated, converted to reduced paid-up or extended term, amended to cut benefits or term, reissued with less cash value, or borrowed against for more than 25 percent of its loan value.

When a replacement is involved, the law requires:

• A "Notice Regarding Replacement of Life Insurance," signed by you and the agent no later than when the application is taken; you keep it (10509.4).
• A list of each policy being replaced, by insurer, insured and contract number, plus copies of printed materials used in the presentation (10509.4).
• Written notice from the new insurer to your current insurer within three working days after the application reaches its home or regional office or the policy is issued, whichever is sooner (10509.6).
• If your current insurer tries to keep the business, a policy summary or ledger statement sent to you within 20 days of receiving that notice (10509.6).
• A notice in the replacement policy of your right to an unconditional refund of all premiums paid, usable within 30 days from delivery (10509.6).

The Department of Insurance lists the downsides: a new contestable period, premiums based on your older age and possible tax consequences. It notes you may be able to amend or convert your current policy instead. I keep the existing policy in place until the new one is issued. Contestability itself is covered on our life insurance page.

Group term life over $50,000 and your W-2

If your employer provides group-term life, the line is $50,000 of coverage. Under 26 U.S.C. 79, the employer-provided cost of coverage is included in your gross income only to the extent it exceeds the cost of $50,000 of coverage plus anything you paid toward it. IRS Publication 15-B explains how employers apply it:

• The cost of coverage above $50,000, minus what you paid toward it, is figured from the IRS uniform premium table (Table 2-2, in 5-year age brackets), using your age on the last day of the tax year.
• That amount is reported as wages in boxes 1, 3 and 5 of Form W-2, and in box 12 with code C.
• It is subject to Social Security and Medicare taxes; withholding federal income tax on it is at the employer's option.
• If the plan favors key employees in participation or benefits, the entire cost is included in their wages.
• Employer-paid coverage on a spouse or dependent may be excluded as a de minimis benefit when the face amount is $2,000 or less.

To qualify, Publication 15-B says the coverage must provide a general death benefit to a group of employees, generally at least 10 full-time employees at some time during the year, with amounts set by a formula that prevents individual selection, such as age, years of service, pay or position. A tax professional can tell you what the box 12 entry means for your return.

How the benefit is taxed, and the transfer-for-value rule

Under 26 U.S.C. 101(a)(1), amounts received under a life insurance contract because the insured died are generally excluded from gross income, whether paid in a single sum or otherwise. Section 101(g) treats two living payments as paid by reason of death: amounts received on an insured who is terminally ill, meaning certified by a physician as expected to die in 24 months or less, and, subject to added limits such as payment for qualified long-term care costs, amounts received on a chronically ill insured.

The exception is the transfer-for-value rule in section 101(a)(2). If a policy, or an interest in one, is transferred for valuable consideration, the excluded amount is capped at the value paid plus premiums and other amounts the new owner pays later. The statute lifts that cap for transfers:

• To the insured
• To a partner of the insured, or a partnership in which the insured is a partner
• To a corporation in which the insured is a shareholder or officer
• Where the new owner's basis is figured in whole or in part from the old owner's basis

Two limits: under section 101(a)(3) these exceptions don't apply to a "reportable policy sale," which generally means a buyer with no substantial family, business or financial relationship with the insured apart from the policy. And a fellow shareholder who isn't also a partner of the insured isn't on the list. Have a tax professional review any transfer first.

Official sources

• Insurance Information Institute: types of term life insurance policies
• California Department of Insurance: Life Insurance and Annuities guide (renewable and convertible term, free look)
• NAIC: Life Insurance Buyer's Guide
• California Insurance Code 10509.2: Definitions for life insurance and annuity replacement
• California Insurance Code 10509.4: Agent duties and Notice Regarding Replacement
• California Insurance Code 10509.6: Replacing insurer duties and 30-day refund
• California Insurance Code 10209: Group life conversion on termination of employment
• 26 U.S.C. 79: Group-term life insurance purchased for employees (Cornell LII)
• IRS Publication 15-B: Employer's Tax Guide to Fringe Benefits
• California Insurance Code 10295.1: Accelerated death benefit provisions
• California Insurance Code 10295.6: Accelerated death benefit disclosure statement and reports
• 26 U.S.C. 101: Certain death benefits (Cornell LII)