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Beware taking tax advice from insurance salesmen…

Posted by taxguru on November 20, 2007

In response to a phone call from a long term client, whose wife’s uncle was being pressured to cash in stocks and replace with annuities, I sent the following:

In regard to your phone call about your wife’s uncle, there are a number of things to consider.  While there are tax free trades possible for some kinds of annuities and insurance policies, he should have a financial pro see if his situation will qualify.

I can’t handle this; so he will need to work with a competent financial advisor.  Some thoughts that did come to mind:

It’s a very serious red flag when a financial advisor puts a rush priority on doing something and doesn’t allow you adequate time to conduct due diligence

There are tons of scammers selling inappropriate annuities to older folks. Google this and you will get a ton of hits.  Annuities generally have huge commissions for the agents; so there is a conflict of interest inherent in any sales pitch.  The push to sell existing investments also smells of account churning to generate commissions.

His reply to me:


Thanks for your input, especially on my wife’s Uncle.


Her brother and I are going to Uncle’s house today…the insurance guy is supposed to meeting him.


I plan on getting the insurance guy’s business card ( if he’s legal, his license number will be on it) then telling him that I am reporting him to the Dept. of Insurance on a complaint for “Elder Abuse”.  Hopefully, he will leave Uncle alone because his license will be in the balance.


Thanks for your help,

More from the client:

Subject: Re: Uncle and the Insurance Salesman

Hey Kerry,


Wife’s brother and I had a meeting with the insurance guy and Uncle today.  The insurance guy is convinced that Uncle can liquidate his stock account under a 1035 exchange and roll the funds into the annuity from the insurance company, without any tax liability……I don’t think so…’s the situation…


Uncle’s stock account is nothing more than a stock account that is traded by his broker, there is some turn-over for some stocks but for the most part, it’s full of AT&T stock, that Uncle received/bought when he retired from AT&T some 30 years ago.  The stock account is not in a “401-K” or an “IRA”, it is not in anything that resembles a deferred retirement account. It is: A managed stock account that happens to be included in Uncle’s Living Trust. In this case, I don’t think this qualifies as a “custodial account”, but I could be wrong, because the broker does “manage” the account by making trades that benefit Uncle, whenever these trades result in a capital gain, Uncle pays the tax, if any, on those specific trades as they happen.


The broker says that there is still a “block of stock” that has not been traded and still has the original “cost basis”. He further says that, when this stock is liquidated, Uncle will have to pay capital gains tax on approx: 54K of “increased value”….


   The insurance guy says, Not so…because the stock account is a “custodial account”,  then there won’t be any capital gains, “we’ll handle it as a 1035 exchange and there will be no tax liability”. He further states that,”All we have to do is liquidate the stock and transfer the money directly to the insurance company and Uncle won’t have to pay capital gains tax because the money never was in his hands.” (this can’t be right)


   I don’t think it is a “Custodial account” just because he calls it a custodial account….right?  


  If Uncle sold a few shares of the original inventory, then he would have to pay some capital gains tax on the difference between the original cost basis and the sales price, right?   Once it is sold, it is sold, period. It doesn’t matter if the check is cut to me or the insurance company, it is sold, there is a gain, because the previous account wasn’t a “tax qualified” account, right?


Frankly, both my brother in law and I believe this insurance guy is blowing smoke, but since he and the broker have their own interests to protect we decided to ask a qualified CPA about the situation.  If the CPA comes back and says that it sounds like Uncle will have to pay capital gains taxes on the liquidated stocks appreciated value, then we’ll tell the insurance guy that our tax professional told us that tax will be due, so Uncle is not doing the deal. Done, Goodbye.


So tell me Mr. Tax Guru… you know of any circumstance where a “managed stock account, not a custodial account, listed in a living trust can be transfered into a life insurance annuity using a 1035 exchange, such that, no capital gains tax will be paid on the liquidated stock” ?


Awaiting your answer,


P.S. I’m not mentioning that the annuity will only let him remove a limited amount of money per year, and that the annuity only pays 3.5% interest while the brokerage has been making Uncle 6% per year, and anytime Uncle needs money the brokerage will not limit how much he removes.


My reply:

I first have to repeat that I am still too overloaded with existing client work to be able to take on any new work; so your uncle really should have his own tax pro to consult with. 

However, this situation is too juicy to resist commenting on.  It sounds exactly like the classic case of a commission hungry insurance salesman preying on trusting elderly folks.  Out of curiosity, how did this sales person come into contact with your uncle?  I don’t see why he would even be considering such a drastic change in his investment portfolio at this time in his life.  It sounds like the salesman bought a list of likely victims (aka gullible seasoned citizens) and did some cold calling.  Am I right?

In terms of Section 1035 exchanges, you are correct and that salesman is blowing smoke up your rear ends.  As a quick web search will confirm, this is a mechanism by which one annuity plan can be swapped for another annuity plan tax free or one insurance policy can be swapped tax free for another insurance policy.  It does not allow for different kinds of investments to be swapped for other different kinds of investments. 

He is also misinterpreting the term “custodial account.”  As you very well know, many investors keep their stock and bond investments inside an account with their stockbrokers for easier transfers.  In regard to how this type of ownership is treated for tax purposes, it is no different than owning the shares directly in your own name.  The stockbroker is considered to be your agent acting on your behalf.  Anything that happens in that account is treated exactly the same for tax purposes as it would be if the assets were owned directly in your own name. 

Likewise, assets held inside living trusts are considered to be the exact same as assets owned directly by an individual.  They are completely transparent for tax purposes while the trust’s owner is alive.

Claiming that this kind of custodial account allows special Section 1035 tax free treatment is either the ranting of an idiot or a con artist.  I’m guessing the latter.

After your mention yesterday of your plans to possibly file a complaint against this guy for elder abuse, Sherry and I were concerned that you might be opening yourself up to a lawsuit.  However, after this additional info, it appears that you do have a responsibility to see that this scammer can’t do his evil work on other folks.

Again, it would be wise to have someone independent of all of your uncle’s investments review his holdings to see if he even needs to make any changes.  It sounds as if he would be much better off sticking with what he has rather than moving to a very restrictive and lower yielding annuity vehicle that just happens to pay a huge sales commission.

Good luck.  I hope this helps.


From the wife:



Thank you so much for taking the time to address this question for us. We needed your outside, independent explanation of whether the 1035 fits this situation because Uncle’s financial advisor is the stock broker (a V.P. at Smith Barney) who was telling him he would have unavoidable tax consequences if he sold his shares & bought the annuity even if the money was transferred directly to the insurance co.

Since the broker is on one side & the ins salesman on the other side of this tug-of-war, we needed your outside expertise to confirm that the broker is right.

I’m truly grateful for your willingness to help us understand this situation better.


Hugs to you & Sherry.


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