Improving a client’s insurance with a tax-advantaged 1035 Exchange

Improving a client’s insurance with a tax-advantaged 1035 Exchange

Your clients who look to change their insurance situations might get a break from the IRS.

A 1035 Exchange (governed by Section 1035 of the Internal Revenue Code) can allow your client to swap a current life insurance, endowment, or annuity policy to a new policy of like kind without paying tax on the investment gains earned on the original contract.

If they meet certain conditions, your clients can exchange outdated or underperforming policies for those with lower costs, a higher death benefit, or, especially in the case of annuities, more-varied investment options. Other reasons your clients may want to exchange a policy (or should consider exchanging a policy) might include improved health or the worry that the future of the insurance company that issued the original policy is in jeopardy.

Getting a break on gains

Under a 1035 Exchange, if all the surrender money from the original policy transfers into the new policy (providing there are no outstanding loans on the original), the gain in the original policy is not federally taxed at the time of the exchange. Surrender the policy without a 1035 and your client will be taxed on the gain from the original insurance contract at ordinary income rates – not as more-favorable capital gains. Any proceeds taken in cash, transferred into a non-like-kind contract, or used to pay off a loan in the exchange will be taxed as ordinary income.

Note that the gain realized is any amount your client received from the cash value of the policy minus the net premium cost, or the total of premiums paid minus distributions received.

 Again, the policies in a 1035 Exchange must be of like kind, making it a “replacement” transaction (though not all replacements are 1035 Exchanges and have the same tax benefits). Like-kind exchanges of policies that qualify include:

  • Life insurance for life insurance, endowment, or non-qualified annuity.
  • Endowment for endowment with a maturity not later than the original endowment, and endowment for non-qualified annuity.
  • Non-qualified annuity for non-qualified annuity.

Note your client cannot exchange an annuity contract for a life insurance policy and get the tax plusses of a 1035.

The Pension Protection Act also allows a 1035 of an existing annuity or life insurance contract for a new one with tax-advantaged long-term care benefits.

Know the catches

There are some considerations; among other conditions, these include the following:

  • Multiple contracts can be exchanged for one contract, but one contract can’t be exchanged for multiple contracts.
  • Ownership changes to the policy aren’t allowed without possible tax consequences. One option is to change the policy ownership before the exchange.
  • The insured also cannot be changed during a 1035 Exchange.

Your client can take a distribution from the original contract before the exchange, but the withdrawal and the exchange run the danger of being taxed as ordinary income. Your client cannot receive a check and apply the proceeds to the purchase of a new insurance policy. Also, though a 1035 avoids federal income taxes, your client may be subject to surrender fees and penalties by the current insurance company.

 A 1035 isn’t always best

Owners of life insurance policies are often subject to sales pressures that may or may not be in that owner’s best financial interest. One carrot can be the tax savings of a 1035 when, in fact, exchanging the policy might cost the policy owner money.

Some sensible questions are best asked first. Your client should learn if their proposed life insurance exchange involves variable products. Has your client’s health worsened since they purchased the original policy? This can result in higher premiums.

 Most types of life insurance policies can include early surrender charges, which will whittle the cash value available toward the new policy; the latter will also likely have its own schedule of surrender charges. The new policy may have a new contestability period, during which the insurance company could challenge a death claim. There may be tax consequences from surrendering the existing policy, such as a tax on outstanding loans from the policy.

Your client should also consider the advantages of surrendering a policy rather than doing a 1035 Exchange. An absence of gain on the existing contract, for instance, negates a 1035’s advantages. If the existing policy is a variable or universal contract that contains a “market rate adjustment” provision, the proceeds received in an exchange may be lower than in an immediate surrender.

A 1035 also generally takes more time than a policy surrender, and a lot can happen to affect your client’s decision-making.