1035 Exchange Rules for Life Insurance

Eric Van Haaften Permanent Life Insurance

If you want to trade in your dusty old life insurance policy for a shiny new one, a 1035 exchange might be just the ticket.

With a 1035 life insurance exchange, you can swap a poorly performing policy for a better one without paying taxes.

Our comprehensive guide will examine how these tax-free transfers work for those who are considering changing their permanent life insurance coverage.

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What are the 1035 exchange rules for life insurance?
Why do people perform a 1035 life insurance exchange?
Should you swap your current life insurance policy?
How do we assist policyholders in transferring policies?
FAQ: 1035 Exchange Life Insurance

What is 1035 Exchange in Life Insurance?

If you want to upgrade your life insurance policy without getting hit with a huge tax bill, a 1035 exchange might be just what the doctor ordered.

This handy little provision in the tax code lets you swap out your old policy for a shiny new one without Uncle Sam taking a cut.

Section 1035 of the Internal Revenue Code states you can exchange one life insurance policy for another without paying taxes on any gains you’ve built up.

That means you can switch to a policy with better coverage, lower premiums, or more features without losing a chunk of your cash value to the IRS.

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What are the 1035 Exchange Rules?

Of course, you need to follow some rules to ensure your exchange is valid. The IRS has only three requirements, or “1035 exchange rules,” for a 1035 transfer to be considered a tax-free exchange.

IRC 1035 requires that both policies’ owner(s) are the same.
You never take direct possession of the money being transferred. So, your cash values must be directly transferred from one insurer to another to be considered a tax-free exchange.
Under section 1035, the new life insurance policy’s face amount equals or exceeds your existing policy.

Reasons for Using a 1035 Exchange

You’re in good company if you’re considering changing your insurance policy.

The NAIC reports that people exchange life insurance policies because of rising premiums, underperforming policies, concerns over the insurer’s financial health, and shifts in personal needs.

Here is how people implement various life insurance exchange strategies to meet their current coverage requirements while avoiding undue tax burdens.

Replacing an Overfunded Insurance Policy

If cash value accumulation is no longer critical, you can buy a new policy to replace your existing “cash-rich” permanent life insurance.

If you’re in good health and can qualify for a new policy, holding excess cash value in your life insurance is unnecessary since insurers retain this amount when you pass away.

Depending on your policy’s cash value, you might maintain the same death benefit with lower premiums or even boost your coverage without raising your costs.

Replacing an Underperforming Insurance Policy

Adjustable life policies were popular in the past because they offered insurance protection and cash value accumulation potential.

However, the extended low-interest-rate environment during the past few decades has negatively impacted these expectations.

Many existing policyholders have seen diminished growth in their cash values, leading insurers to demand higher premiums to prevent policy lapses due to insufficient funds.

To address continued declines in policy values, policyholders can execute a tax-free exchange to a more secure guaranteed universal life policy.

This move secures ongoing coverage without the stress of underperforming cash values or the risk of losing coverage altogether.

Loan Rescue Life Insurance

Typically, if you decided to switch policies, you’d be required to pay off the policy loan first, potentially straining your finances.

However, with a 1035 exchange, you can seamlessly transfer that loan to your new policy without missing a beat.

What’s more, there’s a chance you could secure a lower interest rate on your loan with the new policy, offering potential savings over time.

This can also help you avoid a scenario where the loan balance starts to eat away at your policy’s death benefit, leaving your beneficiaries with less than you intended.

It’s important to note that in a 1035 exchange, the new policy must take on the loan at its current value.

If you exchange a policy carrying a loan for one without, the IRS will consider it partial liquidation and subject you to income taxes.

Upgrading for financial stability

People often consider a 1035 exchange when they are uneasy about the financial stability of their current insurance provider.

It’s wise to periodically review your current insurer’s ratings from agencies such as AM Best, Moody’s, and Standard & Poor’s.

These financial ratings offer insights into an insurer’s ability to pay claims by assigning ratings based on financial reserves and the ratio of premiums collected to claims paid out.

Financially strained insurers often implement cost-saving measures, including reducing credited interest rates on cash values within policies, which can impact long-term performance.

Since whole life insurance is a commitment intended to last decades, ensuring your provider remains financially robust can prevent future complications.

Hybrid Long-term Care Insurance

Another way a 1035 exchange can be a game-changer is if you want to add long-term care coverage to your life insurance.

The Pension Protection Act allows individuals to use a 1035 exchange to purchase hybrid long-term care policies, which combine life insurance with long-term care coverage.

So, you get the best of both worlds, knowing you’re covered if you need long-term care, but you also get a death benefit for your loved ones if you don’t end up needing care.

Hybrid long-term care insurance policies offer payment flexibility. You can choose from a single payment, limited payments, or ongoing annual premiums.

Exchange life insurance for an annuity.

Another big decision you’ll need to make if you’re considering a 1035 exchange is whether to stick with life insurance or switch to an annuity.

When considering swapping your life insurance policy for an annuity, it’s important to weigh the loss of the life insurance death benefit against the potential income stream from the annuity.

Annuities are ideal for retirees needing immediate retirement income rather than aiming to leave a financial inheritance upon their passing.

Many annuities offer guaranteed lifetime payouts, while others feature adjustable withdrawal options to fit various retirement planning strategies.

Should You Exchange Your Insurance Policy?

Before you exchange insurance policies, we recommend contacting a life insurance specialist at Affordable Life USA to conduct a policy audit.

First, our specialist will contact your existing life insurance company to ask questions about your current policy.

How long will your life insurance policy remain active if you continue paying your current premium?
If you cease making payments, how much longer will the policy be in effect?
What’s your policy’s cash surrender value? When transferring your policy, you must avoid surrender charges that can reduce its cash value.

Then, we assess your medical history to identify the most suitable insurance provider for you. This evaluation helps us match you with a company that best suits your health background.

Our team will illustrate various scenarios using your existing cash values, assuming you qualify for new coverage.

First, if there is sufficient cash value, we will evaluate whether you can maintain the same death benefit while reducing or eliminating future premiums.

If you have little cash value or your life insurance needs have changed, we can also evaluate policies with a smaller premium and death benefit.

Finally, illustrations will be generated for the death benefit you require without using your existing policy’s cash value. However, the new policy will be more expensive because it doesn’t utilize your existing cash value.

Executing a Successful 1035 Exchange

One common pitfall with 1035 exchanges is inadequate documentation or incorrect tax reporting, which can lead to unexpected complications.

At Affordable Life USA, our agents have extensive experience adhering to the rules governing 1035 exchanges.

We facilitate insurance transfers by handling all necessary replacement and 1035 exchange paperwork and crafting new policy illustrations.

Be patient because completing all required documentation and executing the fund transfer often spans several weeks or months.

By properly executing a 1035 exchange, you can seamlessly transfer funds from your existing policy into a new universal or whole life insurance plan.

Most importantly, this transition offers you an insurance solution with guaranteed stable premiums and death benefits.

Naturally, before making any changes, you will want to evaluate the cost of a new universal life insurance policy.

You can get started by utilizing our insurance calculator for initial estimates without using any of your existing cash value.

Then, we can make adjustments by adding any transferable cash values later in the process to lower your premiums dramatically.

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FAQ: 1035 Exchange Life Insurance

What is a 1035 Exchange? The IRS’s section 1035 exchange of life insurance falls under IRC section 1035. A section 1035 exchange occurs when the cash in an existing annuity or life insurance policy is transferred to a new policy without any tax liabilities.

What qualifies for a 1035 exchange? The 1035 exchange rules allow a life insurance or annuity contract owner to exchange one product for another without treating the transaction as a taxable sale. You can exchange life insurance for an annuity, but you can’t exchange an annuity contract for a new life insurance policy.

What is not allowed in a 1035 Exchange? According to the IRS, you can not personally receive the cash value of the original policy and use the money to buy a new policy. So, you must directly transfer the funds into a new policy to avoid the risk of losing the 1035 qualification.

Is there a 1035 exchange time limit? You have a 180-day window to execute a 1035 exchange, allowing you to transfer an existing life insurance policy into a long-term care or annuity product without facing any tax implications.

Is there 1035 exchange tax reporting? You will get a 1099-R to report a 1035 exchange to another insurer. But, the exchange is not a taxable event. Just check off the distribution code 6 on your tax form, which notifies the IRS that it was a tax-free 1035 exchange.