Etfs: A Viable Alternative To Life Insurance Policies?

Exchange-traded funds (ETFs) are a type of mutual fund that can be traded on the stock market in real-time, just like stocks. ETFs can be traded on registered stock exchanges, such as the NSE or BSE in India, during market hours. They invest in specific stocks, bonds, or asset classes, and their value changes in real-time as the value of these investments changes. ETFs are often chosen for their low investment costs, high liquidity, and transparency.

Life insurance, on the other hand, is a financial product that provides financial protection to individuals and their families in the event of death or other specified events. There are two main types of life insurance that can be used as a financial asset: whole life insurance and universal life insurance.

While ETFs and life insurance are distinct financial products serving different purposes, it is possible to exchange an existing life insurance policy for a new one without paying taxes on investment gains. This is known as a 1035 Exchange in the United States, as it is governed by Section 1035 of the Internal Revenue Code. However, there are specific rules and requirements that must be followed for the exchange to qualify as tax-free.

Therefore, while one cannot directly exchange ETFs for life insurance, the value of ETFs can be used to purchase a new life insurance policy, or an existing life insurance policy can be exchanged for a new one without incurring tax liabilities under certain conditions.

Exchange an insurance policy for an annuity

If you own a life insurance policy, you might be approached to exchange it for another new policy. While the tax laws make the exchange income tax-free, you might still lose out on the deal. Therefore, it is important to evaluate whether the exchange is right for you before making a decision.

The Internal Revenue Service (IRS) allows you to exchange an insurance policy that you own for a new life insurance policy insuring the same person without paying tax on the investment gains earned on the original contract. This is called a "1035 Exchange", which is governed by Section 1035 of the Internal Revenue Code.

However, there are some important conditions attached to this benefit:

• The old insurance policy must be exchanged for a new policy. You cannot receive a check and then use that money to buy a new policy.
• You can only make a tax-free exchange from a life insurance policy to another life insurance policy or a life insurance policy to an annuity. You cannot exchange an annuity for a life insurance policy.

A transaction in which a new insurance or annuity contract is purchased using the proceeds of an existing policy is referred to as a "replacement". While the term "1035 Exchange" is often used to describe any form of replacement activity, not all replacements are Section 1035 Exchanges and therefore, not all are tax-free.

Reasons to Exchange an Existing Policy

There are several reasons why a policyholder might want to replace an existing policy with a new one:

• Your reasons for purchasing life insurance might have changed over time.
• Improved health or mortality improvements may result in insurance coverage at a lower cost.
• You have concerns about the solvency of the insurance company that issued the original policy or the service of the investment professional or insurance agent.
• A new life insurance policy might have more desirable features or benefits.

Reasons Not to Exchange an Existing Policy

There are also several reasons why exchanging an existing policy might not be beneficial:

• You might reduce the cash value built up in your original policy if a portion of the accumulated amount is applied to the new policy's first-year expenses, including commissions.
• Life insurance policies often include early surrender charges, which can reduce the amount of cash value available for the new policy. The new policy will likely have its own surrender charge schedule.
• Your health may have declined since purchasing the current policy, leading to higher premiums.
• The new policy will have a new contestability period, during which the insurance company could challenge a death claim based on a misstatement in the application.
• There may be unfavourable tax consequences caused by surrendering an existing policy, such as a potential tax on outstanding policy loans.

What to Watch For

Only exchange your life insurance policy if, after knowing all the facts, you determine that the exchange is better for you and not just for the person trying to sell it to you. An investment professional or insurance agent must tell you the important facts about the pros and cons of the exchange and recommend it only if it is in your best interest. They should make this recommendation only after evaluating your personal and financial situation, needs, risk tolerance, and financial ability to pay for the proposed policy.

How to Make a 1035 Exchange

To make a 1035 exchange, contact both your current annuity company and the company offering the alternate contract. They will handle the transaction once you have signed and submitted the appropriate paperwork.

• Contact the new annuity provider and fill out the necessary paperwork, including an application for the new annuity and any compliance forms.
• Notify your current annuity provider about your intention to initiate a 1035 exchange. The new provider will usually provide a letter to send to your current provider to facilitate the transfer.
• Complete and sign all the paperwork provided by both annuity providers, ensuring accuracy and thoroughness to prevent any delays.
• After submitting the paperwork, the two companies will handle the transaction on your behalf, transferring the funds from your existing annuity to the new annuity contract in a tax-free manner.

Pros and cons of exchanging an insurance policy

Exchange-traded funds (ETFs) are a collection of securities that track an underlying index. They are similar to mutual funds but are listed on exchanges and trade throughout the day like ordinary stocks. An insurance industry ETF is an ETF that aims to generate returns equal to an underlying index of insurers.

Pros of exchanging an insurance policy

• The Internal Revenue Service allows you to exchange an insurance policy for a new life insurance policy insuring the same person without paying tax on the investment gains earned on the original contract. This is called a "1035 Exchange".
• Your reasons for purchasing life insurance might have changed over time.
• Improved health or mortality improvements might result in insurance coverage at a lower cost.
• You might have concerns about the solvency of the insurance company that issued the original policy or with the service of the investment professional or insurance agent who sold you the policy.
• A new life insurance policy might have more desirable features or benefits.

Cons of exchanging an insurance policy

• You might reduce the cash value built up in your original policy if a portion of the accumulated amount is applied to the new policy's first-year expenses, including commissions.
• Life insurance policies (other than term policies) often include early surrender charges, which can reduce the amount of cash value available toward the new policy.
• The new policy will likely have its own new surrender charge schedule, which may extend beyond that of the original policy.
• You might pay higher premiums if, for example, your health has declined since the purchase of the current policy.
• The new policy typically will have a new contestability period – a two-year period from the issuance of the new policy during which the insurance company could challenge a death claim based upon a misstatement on the application.
• There may be unfavorable tax consequences caused by surrendering an existing policy, such as a potential tax on outstanding policy loans.

1035 exchange rules

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

To qualify for a 1035 exchange, the existing policy can only be exchanged for a new policy, and the owner and insured person must generally be the same on both the old and new policies. The 2006 Pension Protection Act allows exchanges into long-term care products. A life insurance policy can be exchanged for an annuity, but an annuity cannot be exchanged for a life insurance policy.

A 1035 exchange must be reported on a tax return. If the funds are transferred from one institution to another, the transferring company will issue a 1099-R form, recording the amount transferred and a distribution code to denote a 1035 exchange. Although the transaction is reportable, it is not taxable. If the exchange occurs within the same company, the financial institution may not issue a 1099-R.

A 1035 exchange is particularly useful if you have an old life insurance policy that no longer suits your needs. As you age, your insurance coverage needs may change, and you may find that insuring against potential long-term care needs takes priority. A 1035 exchange can help you transfer your old life insurance policy to a long-term care insurance policy, such as a hybrid long-term care policy (HLTC), which combines life insurance with a long-term care rider.

Despite the tax benefits, there are some important considerations. A 1035 exchange does not absolve the contract owner of their obligations under the original contract. For example, insurance companies typically don't waive surrender charges for 1035 exchanges. Additionally, you may reduce the cash value built up in your original policy if a portion of the accumulated amount is applied to the new policy's first-year expenses, including commissions. It is important to carefully review and compare the features and costs of the existing and proposed policies before making a decision.

Using life insurance as a financial asset

Life insurance can be a financial asset for you to use while you are alive, much like an IRA or mutual fund. Permanent life insurance policies enable you to invest in conservative investments like mutual funds or exchange-traded funds (ETFs).

There are two main types of permanent life insurance that can be used as an asset: whole life insurance and universal life insurance.

Whole life insurance

This is the most common type of permanent life insurance. It offers the policyholder the ability to accumulate cash value. A portion of the premium you pay every month goes into a cash value account. The cash value accumulates over time at a minimum guaranteed rate indicated by your policy. Premiums on these policies typically don't increase over the life of the policy.

Universal life insurance

Universal life policies function similarly to whole life insurance. They allow policyholders to grow an asset by accruing interest over time that can be borrowed against. However, the premiums aren't set and are subject to change. There is also no guarantee on the rate your money will earn over time.

Variable universal life insurance

This is a type of universal life insurance that enables policy owners to invest their earnings into the accounts of their choosing (including mutual funds), so you have the potential to earn more over time.

Using your life insurance as a financial asset

There are several ways to use your life insurance as a financial asset:

• Take out a loan from your policy: You can borrow against the cash value of your permanent life insurance policy. However, if you take a loan against your policy and it's not paid off at the time of your death, any outstanding balance gets subtracted from what your beneficiaries inherit.
• Use your policy as collateral for a loan: You can use your life insurance policy as collateral for a loan, which can make it easier for you to get approved or get a better rate. However, if you die before paying it back, whatever you still owe will come off the top before your beneficiaries receive their benefit.
• Withdraw funds: You can make withdrawals from your policy that are yours to keep. However, if your withdrawal dips into your investment gains, you'll need to pay taxes.
• Receive "accelerated benefits": Some policies enable you to receive your benefits during your lifetime if an unexpected or extreme medical emergency arises, such as cancer, a heart attack, or kidney failure. Most policies allow you to withdraw 25%-100% of your policy's value.
• Surrender the policy (cash out): Surrendering your policy means cancelling your coverage and getting back the cash value you put in, less any fees your insurance company may charge.

Things to watch out for

• Tax implications: While life insurance policies can grow tax-free, withdrawals that dip into investment gains will be subject to taxes. Additionally, there may be unfavourable tax consequences caused by surrendering an existing policy, such as a potential tax on outstanding policy loans.
• Early surrender charges: Life insurance policies often include early surrender charges, which can reduce the amount of cash value available.
• Higher premiums: If your health has declined since purchasing the current policy, you may have to pay higher premiums for a new policy.
• New contestability period: A new policy will have a new two-year contestability period during which the insurance company could challenge a death claim based on a misstatement on the application.
• Reduction in death benefit: Borrowing money from or withdrawing cash from your policy will almost certainly reduce the death benefit.

Exchange an existing policy

If you own a life insurance policy that no longer suits your needs, you might consider exchanging it for another policy. The Internal Revenue Service (IRS) allows you to exchange an insurance policy for a new life insurance policy insuring the same person without paying tax on the investment gains earned on the original contract. This is called a "1035 Exchange". However, there are some important strings attached:

• The old insurance policy must be exchanged for a new policy; you cannot receive a check and apply the proceeds to the purchase of a new insurance policy.
• You can only make a tax-free exchange from a life insurance policy to another life insurance policy or from a life insurance policy to an annuity. You cannot exchange an annuity contract for a life insurance policy.
• Not all replacements are 1035 Exchanges, and therefore, not all are tax-free.

Before exchanging your life insurance policy, be sure to evaluate whether the exchange is right for you and consult with a financial professional to understand the potential tax consequences.

Reasons for exchanging an insurance policy

While there are many reasons why exchanging an insurance policy might not be a good idea, there are also several reasons why someone may want to replace an existing policy with a new one.

Firstly, your reasons for purchasing life insurance might have changed over time. For example, your children may have grown and no longer need support, you may have gotten divorced, or your income or estate may have increased in size.

Secondly, improved health or mortality improvements across the general population might result in insurance coverage at a lower cost.

Thirdly, you might have concerns about the solvency of the insurance company that issued the original policy or with the service of the investment professional or insurance agent who sold you the policy.

Finally, a new life insurance policy might have more desirable features or benefits. For instance, you may want to switch from a term policy to whole life insurance to obtain permanent coverage, or you may want to incorporate a cash value policy into your comprehensive financial plan.

Frequently asked questions