Life Insurance 1035 Exchanges: What You Need To Know

A 1035 exchange is a provision in the Internal Revenue Service (IRS) code that allows for a tax-free transfer of an existing annuity contract, life insurance policy, long-term care product, or endowment for another of like kind. This means that a life insurance policy can be exchanged for another life insurance policy, annuity, or endowment contract, but not the other way around. A 1035 exchange is a good option for those who want to take advantage of the features of a newer policy but don't want to pay additional taxes to make a trade. However, it's important to consult a financial professional to navigate the details and ensure the exchange meets your needs.

What is a 1035 exchange?

A 1035 exchange is a provision in the Internal Revenue Service (IRS) code, named after Section 1035 of the Internal Revenue Code. It allows for a tax-free transfer of an existing annuity contract, life insurance policy, long-term care product, or endowment for another similar policy. This is known as a 'like-kind' exchange.

To be eligible for a 1035 exchange, the owner and insured must be the same on the old and new policies, and the exchange must be between similar products, such as life insurance for life insurance, or a non-qualified annuity for a non-qualified annuity. A 1035 exchange can be a useful strategy for those who want to take advantage of the features of a newer policy without paying additional taxes. It is particularly beneficial for those who purchased a life insurance policy or annuity contract many years ago, which may have less favourable stipulations than those available today.

It is important to note that the rules governing 1035 exchanges are complex, and there may be surrender charges from your old policy or contract. It is recommended that you consult a financial or tax professional before making any decisions.

What qualifies as a like-kind exchange?

A 1035 exchange is a provision in the Internal Revenue Service (IRS) code that allows for a tax-free transfer of an existing annuity contract, life insurance policy, long-term care product, or endowment for another of like kind. This means that the assets being traded must be the same kind of product or be one of the allowable exceptions. For example, you can exchange a life insurance contract for a non-qualified annuity, endowment, or long-term care life insurance. However, an endowment can only be swapped for another endowment, a non-qualified annuity, or long-term care insurance.

The key rules of a 1035 exchange are:

• Exchanges must be in-kind or eligible: The assets being traded must be similar or fall under the allowable exceptions.
• The contract holder doesn't change: Transferring ownership during the transaction would nullify eligibility for the 1035 tax benefits.
• Institutions handle the transaction directly: The exchange must go straight from one institution to another to avoid incurring income taxes. The contract holder cannot take the funds and buy a new policy; the money must be transferred directly.

The primary benefit of a 1035 exchange is that it allows the contract or policy owner to trade one product for another without tax consequences. This means that outdated and underperforming products can be switched for newer products with more attractive features, such as better investment options and less restrictive provisions.

Despite the tax benefits, a 1035 exchange does not absolve contract owners of their obligations under the original contract. For example, insurance companies typically don't waive surrender charges for 1035 exchanges. However, fees may be waived if the owner exchanges one product for another within the same company.

What is and is not allowed in a 1035 exchange?

A 1035 exchange is a provision in the Internal Revenue Service (IRS) code that allows for a tax-free transfer of an existing annuity contract, life insurance policy, long-term care product, or endowment for another of like kind. This means that the exchange can only be done with two similar products, such as from one insurance policy to another.

• A life insurance policy can be exchanged for a non-qualified annuity, but a non-qualified annuity cannot be exchanged for a life insurance policy.
• A life insurance policy can be exchanged for an annuity.
• A life insurance policy can be exchanged for long-term care insurance.
• An endowment can be exchanged for a non-qualified annuity or long-term care insurance.
• A non-qualified annuity can be exchanged for another non-qualified annuity.
• An annuity can be exchanged for an endowment.

• Transfers between qualified accounts, such as IRAs and 401(k)s, are not considered 1035 exchanges.
• The IRS disallows the transfer of funds from the account holder to the institution.
• Exchanges between like-kind accounts where the annuitant or owner on the existing account is not the same on the new account are not allowed.
• An annuity cannot be exchanged for life insurance.
• An endowment cannot be exchanged for life insurance.
• An annuity cannot be exchanged for an endowment.
• Changing ownership is not permitted during a 1035 exchange.

When should you do a 1035 exchange?

A 1035 exchange is a provision in the Internal Revenue Service (IRS) code that allows for a tax-free transfer of an existing life insurance policy to a similar policy. The old policy must be exchanged for a new policy, and the owner and insured must generally be the same on both policies. A 1035 exchange can be a good option in several scenarios.

Firstly, if your life insurance policy no longer suits your needs, you may want to consider a 1035 exchange. As your goals and priorities change over time, you may find that your insurance coverage needs have changed as well. For example, as you age, insuring against potential future long-term care needs may become a higher priority. A 1035 exchange can allow you to transfer your existing policy to a long-term care insurance policy.

Secondly, if you and your loved ones no longer require the death benefit amounts of your current policy and the policy is at risk of lapsing unless you pay significantly higher premiums, a 1035 exchange may be worth considering. This can help you avoid paying higher premiums while still maintaining some level of insurance coverage.

Thirdly, if your existing life insurance policy is not performing as expected, with rising premiums that may exceed the actual death benefit if held to maturity, a 1035 exchange may be beneficial. By exchanging your policy for a new one with better features and investment options, you can improve the performance and potential returns of your insurance policy.

Another reason to consider a 1035 exchange is if you have concerns about the solvency of the insurance company that issued your original policy or the service of the investment professional or insurance agent who sold you the policy. A 1035 exchange allows you to switch to a new insurance company or agent while maintaining the tax benefits of a tax-free transfer.

Finally, if you believe you would qualify for a long-term care insurance policy based on your current health status and age, a 1035 exchange can help you transition to a new policy that better aligns with your current needs and circumstances.

However, it is important to consult with a financial and tax professional before proceeding with a 1035 exchange to fully understand the potential tax consequences and ensure that the exchange aligns with your financial goals and objectives.

What are the advantages and disadvantages of a 1035 exchange?

A 1035 exchange is a provision in the Internal Revenue Service (IRS) code that allows for a tax-free transfer of an existing annuity contract, life insurance policy, long-term care product, or endowment for another of like kind. The benefits and drawbacks of a 1035 exchange are outlined below.

Advantages of a 1035 Exchange

• A 1035 exchange allows you to switch your policy. A life insurance policy purchased when you were younger may not be ideal for you now. Interest rates fluctuate, new products are introduced, and you may want to switch to a policy with better terms.
• A 1035 exchange enables a tax-free exchange. If your 1035 exchange qualifies, you won't have to pay any taxes, even on gains.
• You can switch to a different insurance company. If you have concerns about your current insurer, a 1035 exchange lets you get a policy with a different company.

Disadvantages of a 1035 Exchange

• Doesn't work well with loans. If you have an existing loan on your insurance policy, a 1035 exchange becomes complicated. It's better to repay the loan before making the exchange.
• You may need to pay a surrender fee. If you make the exchange too soon, you may have to pay surrender charges, which reduce proceeds.
• Potentially higher premiums. If you are exchanging a life insurance policy purchased when you were younger and healthier, you may face higher premiums. If your status has changed, obtaining a policy with the same terms may be more difficult, and you may have to pay more.

Frequently asked questions