There are a growing number of life insurance products available. If you have found a new product that better suture needs than your current product, then you might be interested in a 1035 exchange. As with many IRS rules this process can be complicated and potentially backfire if you do not follow all the necessary steps. To determine if this is a good option it is important to understand how a 1035 exchange of life insurance works, when to use it, and any unique situations and issues to keep in mind.
What is a 1035 Exchange?
Section 1035 is a provision in the IRS tax code which allows policyholders to transfer their funds from one life-insurance policy, endowment, or annuity to a new policy without having to pay taxes on the gains made from the original life insurance policy. To preserve the tax deferral features of a 1035 exchange there are strict compliance rules and technical requirements which must be met. If these rules are not met, then you will be forced to pay taxes on any gains.
When to Use a 1035 Exchange
Understanding the basics of how a 1035 exchange of life insurance works is a great starting point but it is equally important to know when to use it as it does not apply to every situation. Everyone has a unique situation but most reasons to use this type of exchange will fall into one of four categories.
1. Change Life Insurance Products
The most common reason people use a 1035 exchange is to change products. Most people consider changing life insurance products to obtain a new type of life insurance or a more sophisticated product which may provide higher returns or better mortality projections. For example, if there is a positive change in your health and or an adjustment in your life insurance company’s mortality projections than a new product may provide more cost-effective coverage or better guarantees.
2. Change life Insurance Coverage
The second reason to use a 1035 exchange is when you are keeping the same life insurance product but are changing the coverage provided by it. For example, if there are changes in family obligations or your estate than a different level of coverage may be better suited to your new situation. This applies to both an increase or decrease in coverage. A common reason for coverage changes is an influx of assets from selling a small business or home. With the extra cash gain from the sale you may no longer need as much life insurance coverage.
3. Change Monthly Premiums
Monthly premiums are always a concern with any type of insurance. A change in your financial circumstances may greatly impact your ability to make premium payments in either a positive or negative way. If you need to alter your monthly premiums, then you will likely be canceling your current life insurance policy and starting a new one. A 1035 exchange may allow you to defer any taxes on gains made in your prior life insurance product when changing to a new one.
4. Opportunity for Lifetime Income
The final reason you may want to use a 1035 exchange is to switch from a life insurance policy to an annuity contract which will provide an opportunity for lifetime income for yourself rather than a lump sum payment to your family later on. As people continue to live longer and medical expenses and the cost of living continues to climb many people find themselves in a situation where an additional stream of income from an annuity provides greater benefits than a future payment from a life insurance policy.
How a 1035 Exchange of Life Insurance Works
There are several requirements you must meet to complete a 1035 exchange. While the specifics will vary based upon your situation and the products being exchanged there are three basic requirements which must be met in every situation.
1. You Have to Exchange the Right Kind of Contracts
The first requirement is making sure you are creating a “like kind” exchange. The American Armed Forces Mutual Aid Association provides clear examples of what are considered like-kind exchanges for 1035 purposes.
“Life insurance for life insurance
Life insurance for endowment
Life insurance for non-qualified annuity
Endowment for endowment, with a maturity not later than the original endowment
Endowment for non-qualified annuity
Non-qualified annuity for non-qualified annuity”
2. The Owner Must Be the Same
The second requirement the contracts must relate to the “same insured”. Fundamentally this means the old and new contract must involve the same person. For example, you cannot use a 1035 exchange to switch from a single life policy to a joint life policy. This is particularly important to keep in mind when dealing with annuities because the IRS issued a private letter in 2003 stating that the term obligee refers to the owner of the contract and is not synonymous with the annuitant.
3. Survivorship Rules – Can Only Go One Direction
There are two basic directions an insurance policy change to/from when the number of people involved change. They can move from joint policies to single policies and vice versa but it is important to note that only one of these exchanges qualifies under the 1035 rules.
• No Single Life to Survivorship Exchanges
A single life policy which insures one person cannot use a 1035 exchange to switch to a new product with a survivorship policy insuring both the same individual and another person.
• Survivorship to Single-Life Exchanges are Allowed
Seemingly in conflict with the previous rule, the IRS does allow that after the death of one insured on a joint policy, the surviving member can use a 1035 exchange to switch to a single life policy.
Unique Situations That May Apply to You
Most people use a 1035 exchange to switch from one policy to another but there are a few unique situations which have become increasingly common.
1. Partial Exchange (Typically for Annuity Contracts)
The first situation is a partial exchange of annuity contracts. While this may apply to some life insurance policies it is generally only seen with annuities. In a 1998 Tax Court case the IRS permitted the exchange of a portion of the value in an existing annuity to be exchange for a new annuity contract if it meets the basic restrictions of a 1035 exchange.
2. Contract has Lost Value
It is becoming more common for people to use a 1035 exchange to preserve a loss utilizing the carryover basis rules. For example, you have a life insurance contract with the cost basis of $100,000 and a cash value of $50,000 but you no longer need the life insurance. Most people would surrender the life insurance policy and buy an annuity, your annuities cost basis would be the $50,000 you put into the annuity. However, if you would use a 1035 exchange, the cost basis of your annuity would be $100,000. This means the first $50,000 of growth in your annuity would be tax free.
3. A Loan Against the Life Insurance Policy
If you have an outstanding loan against your life insurance policy most insurance companies will not issue a new policy and transfer the outstanding loan to the new policy. In most cases, it is a better idea to pay off the outstanding loan before attempting a 1035 exchange because the outstanding loan amount will be considered a distribution which makes it taxable income with rates that vary based on your income. If you choose to do a 1035 exchange without paying off the outstanding loan balance, the amount of your original policy’s basis will decrease to the extent that the loan exceeds the new policies gain which increases your taxable amount in future distributions.
4. MEC Status
If you have a modified endowment contract (MEC) a 1035 exchange will not eliminate the MEC status. MEC’s our insurance policies where the total premiums paid in the first seven years of the policy and exceed the amount needed to provide for a paid-up policy. As a result, any withdrawals or distributions are taxed at ordinary income rates until they exceed the previous gains.
any withdrawal of policy cash value in the first 15 years which reduces the future death benefits often creates an immediate income tax liability and often referred to as a forced out again. When considering a 1035 life insurance exchange it is important to remember the resulting policy of the exchange is considered a new policy which resets the 15-year force out.
6. Tax Implications (Boot & Basis)
The tax concepts of boot and basis can quickly become complex and are most often associated with property or selling stocks. The simple explanation is any money or property received in a 1035 exchange in addition to the value (basis) of the new policy is considered “boot”. Any boots will be reported as a gain by the taxpayer and taxed accordingly. With a 1035 exchange of life insurance policies boot can include any outstanding policy loans and policy withdrawals at the time of the exchange. With an annuity, the boot will be determined by the previous annuities basis although conceptually boot is the same and that it is excess gains which are not moved into the new annuity policy.
Is a 1035 Exchange of Life Insurance Right for You?
If you are in a position to switch from one life insurance policy or annuity to another it is important to understand how a 1035 exchange of life insurance works. As with many financial products which carry special tax rules, in this case tax-deferred status, it is important to take a close look at your individual situation and consult with a professional to ensure you qualify for a 1035 exchange and proceed in accordance with any applicable IRS rules.