You may have heard good things about section 1035 exchanges and life insurance but are unsure about exactly what is a 1035 exchange.
Simply put, a 1035 exchange is a tax free transfer of funds from one permanent life insurance policy to another permanent life insurance policy. Likewise, endowments can be transferred tax-free to other endowments (as long as the maturity date is equal to or before the existing policy) and annuity funds can be transferred to another annuity or to an endowment.
How To Qualify
The Internal Revenue Service sets the policy for these exchanges in section 1035 of the IRS code.
The IRS has only a few requirements to allow for 1035 exchanges:
- The new policy must be of equal or greater value than the existing policy.
- You can’t sell one policy and buy another yourself. The policies must be directly exchanged in a business-to-business transaction. If you take direct control of the funds, you will be taxed.
- The owner and the insured in the original policy must be the owner and insured in the new policy.
How You Can Benefit From A 1035 Exchange
In trying to understand what is a 1035 exchange, the obvious question is: How can such an exchange help me?
There are numerous compelling reasons to switch policies using a 1035 exchange, including:
- If your health status has changed for the better (e.g., you quit smoking), you could qualify for a lower premium or higher death benefit with a new policy.
- You may find an insurance carrier who simply provides a more competitive rate and/or death benefit (relative to your premium) than the company who has your existing policy.
- If your existing policy has accumulated cash value and you don't need the cash, you can use the existing policy to “pay down” the new policy, thereby setting yourself up with a higher face-value death benefit (for the same premium) or lower premiums (with the same death benefit) for the rest of your life. You may even be able to get more face value for less of a premium!
- You may be able to move money in an annuity to a better-performing annuity.
- You can exchange two or more existing policies for one new contract, as long as the other requirements are met. (However, the 1035 rule of thumb—that the new policy must be of like kind—prohibits changing the type of policy. So, for example, you can’t switch from two regular single-life policies to one survivorship policy.)
- You can opt for a lower death benefit on the new policy, thereby lowering premiums.
- You may be worried about your existing carrier’s financial strength and want a more secure policy.
The Bottom Line
Understanding what is a 1035 exchange only gets you started. The process of dealing with your existing and new insurance company on a 1035 exchange can be challenging without professional help. An independent life insurance agent familiar with the market and 1035 exchanges can work with you to:
- determine if a 1035 exchange makes sense for you, including obtaining a “current illustration” (cash/surrender amount) of the existing policy value
- guide you through the process
- make sure you understand the tax issues as well as the benefits and consequences of your new policy.
You stand to benefit significantly from a 1035 exchange, so don’t hesitate to seek out an independent agent who can help you get the most value from the hard-earned money you spend on life insurance.
Photo credit: Ray Tsang