Advantages of a 1035 Exchange

1035 exchange is an exchange of insurance contracts that allows for the deferral of taxes that would be due if the policyowner surrendered one policy and purchased another in two separate transactions. Section 1035 allows the non-taxable exchange of:

  • An existing life or endowment policy for a new life or endowment policy or qualified LTC policy.
  • An existing life or endowment policy for a new annuity or qualified LTC policy.
  • An existing annuity for a new annuity or qualified LTC policy.
  • An existing LTC policy for a new qualified LTC policy.

The Pension Protection Act of 2006 provides tax-free exchanges of qualified LTC contracts from one insurer to another, or from an annuity or life insurance contract to a qualified long-term-care contract without incurring a taxable event. Qualified LTCI riders are eligible as well.

The 1035 exchange allows the policyowner to continue coverage by replacing a contract that no longer serves the best interest of the client with one that is better suited than the original contract. The policyowner’s cost basis in the new contract is the same as the existing contract, since the cost is transferred from the original policy to the newly issued policy (plus any premiums paid and less any dividends received after the exchange). All exchanges not falling under Section 1035 are taxable at the termination of the original policy.

Several requirements must be met to execute a 1035 exchange:

  • The insured (annuitant) and owner must be the same under both policies.
  • The owner must not be in constructive receipt of the surrendered policy cash value. A direct transfer is required by the insurance companies involved. The policyowner must not receive the cash value.
  • These rules do not apply to any exchange involving a non-United States citizen.
  • Underwriting: Full evidence of insurability based on age and amount applies in most exchange products.
  • Compliance with appropriate state replacement regulations always applies.

When to use a 1035 exchange

There are several situations in which it is appropriate to use a Section 1035 Exchange. They include:

• Improvement in insurability.

• To avoid current income taxation on the gain in the “old” contract.

• Reduction in policy expense charges.

• Better policy provisions, riders or other policy features.

• Existing policy is near maturity and will terminate.

• Large cash value resulting in small net amount at risk.

• Concerns with the solvency of the insurance company that issued the original policy or with the service of the agent that sold the policy.

• Policyowners’ needs and/or objectives have changed.

• Existing product is obsolete or underperforming.

A 1035 exchange may not be advisable for several reasons, including:

• The new policy will be subject to a new two-year contestable provision period.

• Insured/owner may not have a need for additional insurance.

• New policy may require additional premiums and may not be affordable to the policyowner.

• The exchange may not be suitable.

• Cash value of the existing policy may be applied to the new life insurance policy’s first year expenses, depleting it.

• Cash value in the new policy may take time to build, whereas the existing policy may be past the higher expense charges of early policy years.

• If the existing policy has a loan, and the loan is extinguished because of the exchange, the amount of the loan may be taxable income. Some insurance carriers will not transfer the outstanding loan balance on life insurance.

• An exchange of a life policy issued prior to June 21, 1988, that would be a modified endowment contract if issued after the effective date of IRC Section 7702A (i.e., fails the 7-pay test), will lose its grandfathered status.

Written by Glenn E. Stevick Jr., CLU, ChFC, LUTCF,  Glenn is an LUTC author and editor, and assistant professor of insurance at The American College.

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