Universal and whole life insurance policies are referred to as permanent life insurance policies. As the name implies, these policies are meant to provide coverage that lasts your entire life. However, in addition to lifetime coverage, permanent life insurance plans also offer the benefit of cash value growth.
For most people, the cash value that a permanent life insurance policy accumulates over the years can help supplement retirement income or even be used in a financial emergency.
With each premium payment paid towards your life insurance coverage, a portion of the premium goes towards the cash account, which will continue to grow. So, theoretically, the longer you keep paying into your policy, the more cash value it will accumulate. However, that’s not always the case, and poor-performing policy can lead to little to no growth.
So, what happens if your permanent life insurance policy no longer fits your current needs? What options exist if you find a new policy offering lower rates, more unique policy features, or better performing cash value accumulation? Are you stuck with your original life insurance policy?
Fortunately, the Internal Revenue Service (IRS) and the 1035 exchange rules allow for the exchange of permanent life insurance policies and cash value accumulation without any tax consequences. That means if you’re eligible for a new permanent life insurance policy, you can take the cash value of your existing policy and apply it to your new policy.
A 1035 exchange can be a smart financial move in certain circumstances. Read on to learn how it works, when it’s a good idea, and what the process involves when you need to initiate one.
Basics of a Life Insurance 1035 Exchange
Section 1035 of the Internal Revenue Code is an IRS provision that allows the cash accumulation of an existing life insurance contract to be transferred to a new cash accumulating life insurance policy without paying taxes on the cash value.
Most 1035 exchanges help policyholders replace outdated life insurance contracts that have performed poorly, providing the potential to obtain a better policy by utilizing the cash value of their existing coverage and applying it to a new policy.
So, for example, let’s say you have a $1,000,000 universal life insurance policy that you purchased twenty years ago. When you bought the original life insurance contract, the cash account had a non-guaranteed interest rate of 8%, building cash growth at a healthy pace.
However, over the last decade, the interest rate had fallen to the guaranteed minimum of 2%. Since the interest rate had dropped, the cash value has not been growing as quickly, and projections show that your cash value will begin to decrease due to increases in mortality costs.
Rather than watching your cash value diminish and running the risk of paying higher premiums in your senior years, you explore the option to 1035 exchange the cash value of your current life insurance policy for a new guaranteed universal life insurance policy.
Utilizing the remaining cash value of your existing policy through a 1035 exchange to a new guaranteed universal life insurance policy, you would reduce your overall cost for coverage and lock into a policy that has fixed rates for the entire contract life. The new life insurance coverage would also give you a policy with new features such as living benefits.
This is one of the significant benefits a 1035 policy exchange can provide.
Federal Tax Law and 1035 Exchange Rules
There are regulations of the Internal Revenue Code that must be followed when you make an exchange. Following these rules will ensure you don’t face federal tax penalties.
Regulations of a 1035 state that:
The exchange of contracts must be of like kind. If you have a life insurance contract, you must exchange it for another life insurance contract. There is an exception in which you can also 1035 exchange funds from a life insurance contract to a non-qualified annuity. However, you cannot 1035 exchange funds from an annuity to a life insurance policy.
Both a life insurance policy and an annuity contract provide for tax deferral. But a life insurance policy offers more tax advantages because it allows for death proceeds that are generally income tax-free under IRC §101(a).
In a 1035 exchange, tax advantages can be given up, but they can’t be increased. So it is possible to make an exchange of a life insurance policy for an annuity, but it is not possible to 1035 exchange an annuity for a life insurance policy.
The owner and insured of both policies have to be the same. IRC 1035 regulations will not allow the funds of an existing life insurance contract to be used from one insured to another. It should also be noted that if a spouse or child was on the original life insurance contract as an insured rider, then the new policy does not need to include them.
The cash value funds received from a 1035 life insurance contract must be transferred directly to your new policy and not into a personal bank account. This is because depositing funds into your bank account could eliminate the tax-free benefit of a 1035 exchange.
Types of Life Insurance You Can Use For 1035 Exchange
Not all life insurance products are eligible for a 1035 exchange. A successful 1035 is an exchange of a (non-qualified) life insurance policy, endowment contract, or annuity contract for another contract where the exchange meets the requirements of Internal Revenue Code (IRC) §1035.
For example, you’ll need a permanent life insurance policy offering a cash value component to use a 1035 exchange, such as whole and universal life policies. On the other hand, term life insurance, which is temporary coverage and offers no cash component, is generally not eligible for a 1035 exchange in most cases.
You can read more about these two types of life insurance policies below.
Whole Life Insurance
Whole life insurance is permanent life insurance with a guaranteed cash value component. Therefore most whole life insurance plans can accept a 1035 exchange from another life insurance policy. The only case where a 1035 to whole life insurance is generally not allowed is when the whole life insurance plan is considered non-participating or non-par for short.
A non-participating whole life insurance policy is a whole life policy that builds guaranteed cash value but is not eligible to receive dividends. Based on their structure, they generally cannot accept 1035 funds from another life insurance policy.
The type of whole life insurance that can accept a 1035 exchange is often associated with participating plans. These are whole life insurance policies that can receive dividends. With participating whole life insurance, you will pay much more for your life insurance coverage than any other type of life insurance.
A large part of that is due to how the cash account works. For example, whole life insurance offers a guaranteed cash value. With each premium payment, a pre-determined portion goes towards the cash account. Ultimately, your cash account should equal the full death benefit when the policy reaches maturity which is the reason why a larger premium is needed.
Universal Life Insurance
Universal life insurance is another form of permanent life insurance with a cash value account. As with whole life insurance, universal life insurance can accept a 1035 exchange from another life insurance contract.
A large portion 1035 life insurance exchanges often occur from older interest-based universal life insurance plans that initially had a high-interest rate but have since fallen due to economic times.
Many of today’s universal life insurance plans, such as guaranteed universal life and indexed universal life, have been restructured to offer better life insurance protection at a much lower cost than a whole life insurance plan.
Examples of a Qualifying 1035 Exchange
Only certain exchanges qualify for 1035 tax-free exchange. If you’re starting with a life insurance policy, you can switch to the following:
- Another life insurance policy
- An endowment contract
- A non-qualified annuity contract
- A qualified long-term care contract
So, for example, let’s say you currently have a whole life policy that has been building cash value. Since you purchased your policy, you’ve quit smoking, lost weight, and lowered your cholesterol.
You’ve been shopping around and know that with your improved health, you’ll be able to get a new policy at a lower rate. In this case, a 1035 policy exchange for another non-qualified life insurance plan may fit your improved health and current life insurance needs.
However, not all exchanges qualify for 1035 exchange. For example, exchanges that do not qualify for a 1035 exchange include:
- An annuity contract for a life insurance contract.
- Survivorship life insurance contract for a single life insurance contract (unless only one insured is still living)
- Single life insurance contract for a survivorship life insurance contract.
How Is a 1035 Exchange Completed?
There are steps to follow for successful policy exchange. However, the insurance company will handle a large part of the exchange process. It is also a good idea to keep all the paperwork from your exchange for tax reporting purposes later. Steps in a 1035 policy exchange include:
Do not cancel your current coverage. Before considering any exchange, you will want to contact your current insurance company to learn of any potential surrender charges of your existing life insurance contract. Most life insurance contracts have at least a ten-year surrender charge where the insurance company will charge a fee towards the cash account if you surrender your coverage within the ten years.
Complete an IRC Section 1035 Absolute Assignment exchange form which your life insurance agent should provide as part of the new application process for coverage. This form will transfer all rights in the current life insurance policy to the insurer who will be issuing the new policy.
Upon approval of your new coverage, you must confirm that the new insurance company has received the 1035 funds from the existing policy. If they have and you have accepted the new coverage, you may need to submit a surrender request to your current life insurance company so that the insurance coverage is canceled.
You should not cancel any life insurance coverage until you have been approved, confirmed that the 1035 has transferred, and you have accepted your new policy.
Remember that the money in your cash value account needs to go directly into your new life insurance policy. Completing the IRC Section 1035 Absolute Assignment form will notify the insurance company to send the 1035 funds to the new insurance company.
Advantages to Changing Your Existing Life Insurance Policy
Exchanging policies can be a smart idea in some situations. There are multiple potential advantages to changing your policy. 1035 advantages may include:
- Your current policy is performing poorly.
- Many newer life insurance products (as well as policy riders) unavailable a few years ago are available today.
- Your family, business, and financial status and objectives may have changed, and the insurance purchased to meet those objectives may also need to be changed.
- You can get better rates on a new policy because your health has improved.
- You’ve found a policy at an insurance company with a better financial reputation.
Disadvantages to Changing Your Existing Life Insurance Policy
A 1035 exchange isn’t useful for everyone. There are some disadvantages to switching life insurance policies. In some cases, the disadvantages can outweigh any potential benefits. 1035 disadvantages include:
- The clock on your two-year contestability period will restart. The two-year contestability period is the window after your policy begins when the insurance company might challenge a death claim against your policy if your death seems to contradict the information provided on your application.
- Most whole and universal life insurance policies have early surrender charges. This will reduce the policy’s cash value.
- If your health has declined, a new policy might be much more expensive or potentially not attainable.
- If you’ve borrowed against the cash value of your current account and haven’t paid it back yet, a 1035 exchange may not be allowed until the policy loan is paid back.
1035 Exchange Considerations
Your personal health and financial circumstances will determine if a 1035 exchange is right for you. There are a number of factors that can help determine if switching policies could be beneficial for you. If you’re considering making a policy exchange, it’s a good idea to make sure you consider:
- Are you able to get a policy of the same size or larger than your existing policy?
- Has your health improved or declined since you purchased your current policy?
- Can you get a higher death benefit if you switch to a different insurance company?
- Are you happy with your current policy?
- What is your current policy lacking?
- What are you looking for in a life insurance policy?
- How much money is in your policy’s cash value account?
- How much interest has your cash value account earned?
- Would an exchange cost, save, or earn you money?
Talking to a financial professional, tax professional, legal professional, or licensed insurance agent can help you decide if a 1035 is a good fit for your financial situation.
They can help you explore your options, look into any tax benefits, and make sure switching policies is the best move. It can be a good idea to seek guidance from a professional before you make an exchange, especially if you’ll be moving a large cash value account.
Frequently Asked Questions About 1035 Exchanges
You can read answers to some common questions about 1035 exchanges below.
What qualifies for a 1035 exchange?
You need to be the owner of a life insurance policy with cash value, and you need to be switching that policy for one of equal or greater value. The switch needs to be either another life insurance policy or for an annuity contract. Additionally, both the old and new insurance policies must insure the same person.
What is a 1035 annuity contract exchange?
A 1035 annuity contract exchange allows you to exchange one annuity for another, or to exchange a life insurance policy for an annuity. Either exchange will be tax free. Both the old and new annuity contract, or the life insurance policy and the annuity, must have the same contract owner to qualify for a 1035. You can’t exchange an annuity contract for a life insurance policy.
Should I do a policy exchange?
Your personal circumstances will determine if a 1035 will be a good financial move. For instance, if your health has improved since you bought your whole or universal life policy, making a policy switch could save you money.
Suppose you have an older life insurance policy, especially an older universal life insurance plan purchased in the 80s or 90s. In that case, it’s a good idea to request a performance illustration from the life insurance company to check for any red flags.
As mentioned, many of the older universal life insurance plans started with high-interest rates that have since gone to the guaranteed minimum resulting in low cash value growth. So in many cases, if you have one of these poor-performing universal life insurance plans from the past, you’re likely to find a better policy with how today’s permanent plans have been designed.
However, if your health has declined, switching your life insurance policy might not benefit you. The best case is to work with a licensed agent who can review your current life insurance coverage performance to see if a 1035 exchange to a new policy will benefit you in the long run.
Do I have to report a 1035 exchange on my tax return?
You will receive an IRS form 1099-R to report your life insurance product exchange when you file income tax. However, you won’t pay any tax. The exchange is tax-free, but it needs to be reported. The 1099-R should have distribution code (6) marked off, indicating that the exchange is a zero-taxable amount.
What if I have a loan out from my current policy?
It’s best to pay your loan off before attempting a policy exchange. If your loan is still active and you choose to continue with a 1035 exchange and decide not to pay back the loan, balance you will likely face tax consequences called a boot.
A boot is generally defined as any value from an old contract that is not transferred to a new contract. The boot is taxable to the extent that there was a financial gain in the old contract. Boot in a 1035 transaction includes:
- Any outstanding loans that are not repaid and are not mirrored in the new contract.
- Any cash value from the old life insurance contract that is not applied directly to the new life insurance contract.
In addition, some companies will not accept a 1035 exchange if you have an outstanding loan balance on your current policy.
If a company accepts a 1035 exchange with an outstanding loan, they may allow the loan to be carried over to the new contract, which is referred to as a “mirrored loan.” If the new life insurance company allows for the loan balance to be mirrored, it will prevent a taxable event.
What is a surrender fee?
A surrender fee is an administrative fee you’ll be charged to cancel your life insurance policy. Term life insurance policies don’t have surrender charges, but most permanent life insurance policies do.
Surrender charges are usually a percentage of the amount you’ve paid into your policy. In most cases, that percentage will be highest in the first year of your policy, decreasing every year until it hits zero. For most policies, this is after about ten years.
Some life insurance companies will waive surrender charges if you are doing an internal exchange.
Can I keep the money from my old cash value account while I wait for a new policy to be approved?
The money in your cash value account has to be transferred from one life insurance cash value account to another life insurance cash value account. This process has to be done through the life insurance companies. You can’t hold on to the money or transfer it yourself. This does not qualify as a 1035 exchange, and you will have to pay taxes on the money.
A policy exchange can help you switch out of a poor-performing contract and save money. In addition, it’s a great way to keep the cash value and interest earned in a whole or universal life policy and apply it to a policy that suits your needs better.
If you have an old cash value life insurance contract and are worried about future performance, reach out to us so we can help review your existing coverage to see if you could benefit from a 1035 exchange.
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