***BC Brokerage is an insurance brokerage - we are not tax professionals. Please consult with your Certified Public Accountant (CPA) before making any 1035 exchanges.***
By definition: A 1035 exchange is a provision in the Internal Revenue Service (IRS) code allowing for a tax-free transfer of an existing annuity contract, life insurance policy, long-term care product, or endowment for another one of like kind.
To qualify for a Section 1035 exchange, the contract or policy owner must also meet certain other requirements. Both full and partial 1035 exchanges are permitted, although some rules will vary by company. Typically, 1035 exchanges between products within the same company are not reportable for tax purposes as long as the IRS criteria for the exchange are satisfied.
Why a policy owner would complete a 1035 exchange:
No taxable event
The primary benefit of a 1035 exchange is that it lets the policy owner trade one insurance product for another with no tax consequence. 1035 exchanges allow policy holders to exchange outdated and underperforming products for newer products with more attractive features. We often call this as the "old vs. new" type of insurance.
1035 and Original Cost Basis Transfer
1035 exchanges also allow policyholders to preserve their original basis, even if there are no gains to be deferred. Example, Robin Smith paid premiums totaling $150,000 (her cost basis) in a non-qualified annuity and subsequently took no loans or withdrawals. But because of poor product performance, its value dropped to $125,000. Dissatisfied, Robin Smith decided to transfer her funds into another annuity with different insurance company. In this example, the cost basis of the original contract of $150,000 becomes the new contracts' basis, although just $125,000 was transferred to the new annuity contract.
Avoid Modified Endowment Status
This mainly applies to permanent insurance products, including, but not limited to: Universal Life (Traditional, Indexed, Variable) and participating Whole Life (dividend based) insurance products. If a policy owner has made subsequent premiums payments into a new insurance policy, other than the exchange proceeds, within the new 7-pay limit, then a 1035 Exchange of a life insurance policy allows the policyowner to place the original contract’s entire value in the new policy without creating a modified endowment contract, or MEC. Using a 1035 in this situation lets the new policy start with a higher initial cash value than what would be the case if the original policy were simply surrendered and a new policy purchased, not to mention any possible surrender charges.
What doesn't change during 1035 exchanges
Despite the possible tax benefits, 1035 exchanges do not absolve the policy owner of their obligations under the original insurance contract. This is very common practice for surrender charges. Insurance carriers typically do not waive surrender charges for 1035 exchanges. However, if the owner exchanges one product for another within the same company, the fees may be waived, on rare occasion.
When is a 1035 exchange appropriate?
All consultation on replacing an insurance policy must clearly be in the best interest of the policy owner, no exception.
The policy owner should be fully educated by a trusted insurance broker about the advantages and disadvantages of the transaction. Existing insurance should never be terminated before a new policy is placed inforce.
A replacement can be justified on either an economic or personal basis. Here is a list of things to consider before making any changes to your insurance:
Consider alternatives to replacement: change of plan with the existing insurer, additional coverage with the existing insurer, and repaying policy loans.
Consider any differences in additional benefits offered on the existing policy and the new policy.
Consider the applicant’s health - if their health condition has declined since the original policy was taken out, the applicant may get a worse health rating, thus increasing insurance premiums.
Consider new contestable and suicide provisions on the new policy.
Client's insured age - there may be a higher premium rate for the new coverage because of issuance at a higher attained age
Consider the impact of any surrender charges that may occur on the surrender of the existing policy
Consider any differences in policy provisions and guarantees.
When is surrendering a policy better than a 1035 Exchange?
A 1035 exchange is 99% of the time almost always more time consuming than a policy surrender. The timing of a 1035 is uncertain and the process can take several months to complete.
If there is no gain on the existing contract, or if there are loans outstanding that may represent a partial gain, a 1035 exchange would not offer any advantage to the policy owner.
For permanent insurance policies - if the existing insurance policy is a universal life or whole life contract that contains a “market rate/company performance adjustment” provision, the proceeds received in a 1035 exchange may be lower. This may depend on market conditions and the time it takes to process the exchange as well. Some carriers take 90 days (3 months) to process a 1035 exchange.
Have a current policy you would like to review? Securely upload a policy here for a complimentary insurance audit here at BC Brokerage
***BC Brokerage is an insurance brokerage - we are not tax professionals. Please consult with your Certified Public Accountant (CPA) before making any 1035 exchanges.***
BC Brokerage
765.730.7146
Indianapolis, IN.
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