Sometimes things just don’t work out the way we planned. The longer the time frame with which we’re dealing, the more that seems likely. Sometimes we end up with a life insurance or annuity contract that just doesn’t meet our needs. It seems as though there should be something we could do to make the situation better.
Often there is. Life insurance policies and annuity contracts are tools we get for the long-term. The long-term, however, doesn’t always work out the way we thought it would. This can lead to situations in which we have insurance products that no longer meet our needs.
For example, an individual might have a life policy they put in place to provide for the ongoing needs of their spouse or significant other in the event of the individual’s premature demise. But the spouse or significant other, for one reason or another, is no longer in the picture.
The policy owner has a policy that no longer has a purpose.
Perhaps an investor purchased a fixed-annuity contract a number of years ago with what seemed to be an attractive interest rate. Now the contract doesn’t even keep pace with inflation. It is clearly not meeting the investor’s needs. Perhaps they have a variable annuity with high costs and few investment options.
The problem for the contract owner is that surrendering the contract may create a big tax liability. They need a better solution. An exchange under section 1035 may be the answer.
1035 Exchange Overview
Section 1035 of the Internal Revenue Code allows for the exchange of an insurance contract for another contract. True to IRS form, there are many restrictions.
You can exchange a life insurance policy for another life insurance policy or an annuity. You can exchange an annuity for an annuity. But you cannot exchange an annuity for a life insurance policy.
You can exchange a life insurance policy or an annuity for a qualifying long-term care contract. This is legal but problematic, as there don’t seem to be any companies currently offering long-term care that you can purchase with a single payment.
Exchanging one policy for another allows the cost basis to transfer from the existing policy to the new policy.
If you have a gain, you roll that gain into the new policy. If you have a loss in the existing policy, that higher basis transfers, preserving your existing loss to use against future gains.
The exchange has to keep the owner and insured the same. Partial exchanges are allowed, as are multiple exchanges into a single contract.
This can be useful if an individual has a number of small insurance policies, each with its own set of costs, and would like to replace them with a single, more efficient, policy.
You can’t go the other way: You can’t exchange a single policy for a group of policies.
1035 Exchange Logistics
Policy owners cannot just go out and cancel a policy and buy another and call it a 1035 exchange. That doesn’t meet the requirements and will cause the very tax problems they seek to avoid.
To qualify as a tax-free exchange under section 1035, the owner cannot have beneficial use of the money.
The money has to go directly from the existing company to the new company.
A financial advisor or insurance agent should be able to help with the necessary paperwork for the replacement transaction. It’s a little complicated, but not uncommon. People do these all the time.
Existing policy loans can cause major problems. Most companies won’t issue a life insurance contract with a loan against it. In most cases, you would need to pay off the loan prior to making the exchange.
If your existing life policy is a modified endowment contract (MEC), the new policy will likewise be a MEC — and you can’t use section 1035 to escape from that.
Section 1035 applies only to non-qualified contracts.
If you have an annuity within a retirement plan, you can surrender it and get something else within the plan without tax consequences, no 1035 exchange needed. Be careful, however, of surrender charges.
There are a number of potential positives from a section 1035 exchange:
- Tax-free transfer to a policy better suited to your present needs
- Preserve cost basis — you don’t have to give up a loss in an existing contract
- Possibly reduced costs; newer contracts may have a lower cost of insurance
- Newer contracts may have more or more desirable features not available on the existing contract.
- Newer contracts may have more, or more appropriate, investment options.
- You may not be comfortable with the financial health of the existing company.
There are, however, also potential negatives, and there are reasons to approach a section 1035 exchange cautiously. Some potential downsides to the transaction:
- The new policy will most likely have surrender charges.
- The existing policy could have still have surrender charges.
- The new policy may have new contestability and suicide periods.
- The new policy could have higher costs.
- You could forgo future dividends on an existing policy.
- You can’t change ownership at the time of exchange in most cases.
The Bottom Line
One thing insurance agents tell consumers constantly is that they should never replace their existing policies. Sometimes that’s good advice; other times it is not.
It is rare that it’s a good idea to exchange a policy for a nearly identical one. For example, it may not make sense to exchange a whole life policy for another whole life with the same death benefit. You might not gain enough to make up for what you would lose.
It can make a lot of sense, however, to replace a group of four or five insurance policies with one policy. There are efficiencies to be gained with a single policy with a single policy fee and potentially lower cost of insurance due to both the age of the policy and insurance rate banding.
Larger insurance policies generally have lower rates of insurance than their smaller counterparts do.
It can make a lot of sense to replace a stodgy fixed annuity with a variable annuity if you could benefit from more growth potential.
It can make a lot of sense to take a policy that is not meeting your needs and replace it with a policy that can meet your needs.
There’s still no free lunch. But for investors who have a policy that is not meeting their needs IRS section 1035 allows for the tax-free exchange into another contract. That may give the investor the opportunity to get something more suitable for their money. And that could pay off in the long run.