Most insurance advisors will have knowledge of how a 1035 exchange works. From time to time clients or prospective clients will have a life insurance, annuity, or endowment policy that is no longer a good fit for them. When this situation arises, the insured can exercise a 1035 exchange to a new policy. This means they can transfer all of the cash value and their basis from the old under-performing policy to a new up to date policy.
The section 1035 tax-free exchange allows the insured to move cash value from a life insurance policy to another life insurance policy or tax-deferred annuity without paying any taxes on the gain in the policy. The same can be done with a tax-deferred annuity. If doing a 1035 exchange on an annuity, the only transfer option is another annuity.
Believe it or not, consumers dictate what life insurance companies offer in their product lineup. These companies listen and make changes to their products all the time. It seems that these life insurance products get better every year and companies will follow suit.
We now see chronic illness benefits and critical illness benefits added to most permanent policies these days. We see capped variable loan rates on indexed universal life insurance policies. I don’t know of any universal life insurance policies that don’t come with an over loan protection rider.
More and more companies are getting into the indexed universal life insurance space due to the overwhelming demand. Even variable universal life insurance policies are getting better.
But what if you have an old policy that is just average? Maybe you should consider a 1035 exchange.
The challenge in this scenario is that most consumers aren’t familiar with the 1035 exchange rule and get somewhat confused if their insurance professional doesn’t explain it properly. The intent of this article is to help the consumer better understand the 1035 exchange transaction. Here, we’ll discuss what a 1035 exchange is and how to avoid tax costs by using it.
What is a Section 1035 Exchange?
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A Section 1035 Exchange is a very beneficial rule that was promulgated in Section 1035 of the Internal Revenue Code and allows a person that owns a life insurance policy or annuity to exchange the value in one product for another product without being subject to taxes on investment gains earned in the original contract.
As is typical with any IRS rule that benefits a taxpayer, there are two very important conditions that must be met to exempt the transaction (exchange) from tax liability:
- The tax rule states that the original insurance policy must be exchanged for a new insurance policy – you cannot receive a surrender check from the company and then apply the proceeds to the purchase of a new insurance policy.
- The tax rule also states that you can make a tax-free exchange from 1) a life insurance policy to another life insurance policy or 2) a life insurance policy to an annuity. You are not allowed to do a 1035 exchange annuity contract for a life insurance policy.
With life insurance getting more competitive and better products designed for cash accumulation, 1035 exchange life insurance deals are being made more than ever before. The same thing is happening with 1035 exchange annuity transactions.
What’s the Purpose of a 1035 Exchange?
The purpose of the section 1035 exchange is straightforward. It is used to reduce or eliminate possible tax liability when you use the accumulated cash in one outdated product to purchase a new cash value policy that is a better fit for your individual circumstances.
When a consumer uses the section 1035 tax-free exchange, it allows them to purchase a more desirable product that can better meet their financial needs. In most cases, this tax-free transaction is used to go from an outdated insurance or annuity product to a newer one. It is important to note, however, that the transaction must not generate a gain or loss so that it qualifies as a non-taxable event.
Why Should I Use a Section 1035 Exchange Life Insurance Transaction?
There are several very good reasons to use the 1035 exchange life insurance transaction, and all of them result in preserving wealth.
When is a 1035 Exchange Allowable and Tax-Free?
With any transaction where the IRS has specific 1035 exchange rules, there are qualifications that must be followed so the transaction is considered allowable.
- When you are going to replace one insurance policy, annuity, or endowment contract with another insurance, annuity, or endowment contract, the owner, named insured or annuitant must remain the same on the new contract as listed on the old one, however, an ownership change is allowable after the 1035 exchange has been completed.
- The exchange must be handled directly between the insurance carriers to be considered a tax free transaction.
- The exchange must be considered “like-kind” which means you can exchange your life insurance policy for another life insurance policy, endowment, or non-qualified annuity. You can exchange your endowment for another endowment as long as the new endowment’s maturity date is no later than the original endowment maturity date. You can also exchange an endowment for a non-qualified annuity and you can exchange a non-qualified annuity for another non-qualified annuity.
- You can exchange more than one contract for another contract, but you cannot exchange one contract for more multiple ones. For example, you cannot do a 1035 exchange life insurance for life insurance and at the same time attempt a 1035 exchange life insurance to annuity transaction.
We work on 1035 exchanges regularly and can guide you through the process
First of all, keep in mind that this is life insurance and as such, medical underwriting will be required just like when you purchased the original policy.
Several recent events have created a spike in section 1035 exchange or replacement activity. There have been several major companies that have stopped selling life insurance or raised the insurance rates on in-force policies.
This is a major concern since permanent life insurance policies are meant to provide coverage for 20, 30, 40, and 50 or more years. If this has happened to you, we can review your policy and help you to find a solution. Not all insurance professionals are experienced in the 1035 exchange rules for life insurance as we are.
What would you do if you purchased a universal life policy 10 years ago only to find that your company is raising your rates? You will probably look into changing companies.
Many of our new clients are coming to us today because of this issue. As long as your health is good, you should be fine. There are many great policies from many top IUL companies available today that were not available 10 or 20 years ago.
So what are we seeing most? We have clients that want a guarantee that their policy will be around when they die. They are good with paying the premium but they want guaranteed premiums and a lifetime guarantee that their policy will stay in force as long as those premiums are paid.
Variable Universal Life
The Variable Universal Life (VUL) market has been on a great run over the last 8 years and variable universal life insurance policies have performed well. Many of our new clients see the writing on the wall with their variable policies and want to move to a safer policy that will not lose any value.
Indexed Universal Life
Indexed universal life insurance is a great option for a 1035 exchange since there is no risk of your policy losing value due to a downturn in the stock market. This is a great time to lock in the value of your policy with a 1035 exchange.
Single premium policies are also on the rise. Many of our new clients no longer want to pay any premiums for their life insurance. We can take the lump sum from the 1035 exchange and dump it into a life insurance policy that will require no further premiums. It will be completely paid up.
If you are someone that has an old cash value policy and wants an income from it, a 1035 exchange annuity may be a good option. Remember, we can go from a life policy to an annuity and not run afoul of the 1035 exchange rules for life insurance.
What is a 1035 Exchange Drawback?
As with any insurance product, there is no guarantee that every transaction will be free of drawbacks. These drawbacks, however, are typically the result of product rules and not because of tax liability or breaking any of the IRS 1035 exchange rules.
- There are limits on allowable transfers – Although you can exchange an insurance policy for another insurance policy, non-qualified annuity, or endowment, you cannot exchange a non-qualified annuity for a life insurance product. You may, however, exchange insurance policies or non-qualified annuities for long term care products thanks to the Pension Protection Act of 2006.
- Surrender Fees – Even though you are exchanging one product for another, you may still be liable for surrender fees for leaving a contract early. In some cases, if your exchange is within the same insurance company, that company may elect to waive surrender fees since you are staying with that insurance company.
- Health Underwriting – Since life insurance rates are based primarily on an applicant’s age and health status, exchanging an older policy for a newer one may not be an appropriate choice if the applicant has developed health issues that could lead to being rated up or even declined under the new application.
- Contestability Period – Anytime a new insurance policy is issued, the insurance company is entitled to a contestability period (normally two years) when they can investigate a claim and delay or even deny coverage if they find that the applicant has misrepresented themselves on the insurance application.
What is a partial 1035 Exchange?
A partial 1035 Exchange applies only to annuity products. The rule allows an annuity owner to exchange part of an annuity contract directly for another annuity contract and still qualify as a tax-free exchange. However, the IRS has already issued Revenue Procedure 2008-24, which radically impacts the subsequent tax treatment of the two annuity contracts involved in the partial 1035 exchange.
Anyone planning to transact a partial 1035 exchange should be completely familiar with the rules attached by the IRS or have an experienced insurance or annuity professional to effect the transaction so that no unintended tax liability results from the partial 1035 exchange transaction.
Bottom Line on 1035 exchanges
Many old under-performing universal life, indexed universal life insurance or whole life policy can be upgraded to the newest and greatest policies that life insurance companies are offering. Make sure you talk with a knowledgeable life insurance agent to find what move is best.
The last thing you want to do is create a taxable event just because you didn’t follow the 1035 exchange rules.
Frequently Asked Questions
What is a 1035 tax free exchange?
The 1035 tax free exchange allow the insured to move cash value from a life insurance policy to another life insurance policy or tax deferred annuity with out paying any taxes on the gain in the policy. The same can be done with a tax deferred annuity. If doing a 1035 exchange on an annuity, the only transfer option is another annuity.
What is the purpose of a 1035 exchange?
The purpose of the 1035 exchange is straightforward. It is used to reduce or eliminate possible tax liability when you use the accumulated cash in one outdated product to purchase a new cash value policy that is a better fit for your individual circumstances.
Are there any limits on a 1035 exchange?
Although you can exchange an insurance policy for another insurance policy, non-qualified annuity, or endowment, you cannot exchange a non-qualified annuity for a life insurance product. You may, however, exchange insurance policies or non-qualified annuities for long term care products thanks to the Pension Protection Act of 2006.
Is there a 1035 Exchange Real Estate?
Yes, but it is a 1031 Exchange that allows the owner of an investment property exchange it for another property and any capital gains taxes would be deferred.