Most insurance professionals must deal from time to time with a client or prospective client that has 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 from the old under-performing policy to a new up to date policy.
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.
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.
Table of Contents
What’s 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 It is used to reduce or eliminate possible tax liability when you use the accumulated cash in one outdated product to purchase a new cash value policy that is a better fit for your individual circumstances.
When a consumer uses the 1035 exchange without a tax liability, 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 In most cases, this tax-free transaction is used to go from an outdated insurance or annuity product to a newer one.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 1035 Exchange?
There are several very good reasons to use the 1035 exchange, 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 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.
Are there any Drawbacks with a 1035 Exchange?
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.
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.
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.
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.
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.
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 rules.