Just like you sometimes sell your house to buy a new one, you can use 1035 exchanges to exchange one life insurance policy for another without tax consequences.
In this article, we will learn more about 1035 exchanges and take a closer look at how they work as well as the factors that go into deciding if they are a good choice for you.
This article is written as general education, and should not be considered as personal financial advice. If you would like personal guidance with life insurance, you can schedule a time to talk with one of our experts.
What is a 1035 exchange?
A 1035 exchange is a tax-free exchange of one life insurance or annuity for another (or several others), where the owner and the insured person stays the same.
The exchange gets its name from being regulated under section 1035 of the IRS tax code, which is a part of the tax code that deals with like-kind exchanges - ie. different types of transactions when one asset is switched for a similar one and can avoid taxes on any capital gains.
Another example of a like-kind exchange is the 1031 exchange, which similarly allows tax-free real estate exchanges when proceeds are rolled into a new property.
The 1035 rule makes it easier to stay flexible and continuously ensure that you have the optimal policy for your goals.
Without the 1035 rule, any surrender of a policy (ie. cancelling the policy and cashing out available policy values) would be taxed as ordinary income, which is something that always should be avoided.
To maintain the tax advantages of permanent life insurance, policyholders need to hold onto some policy for their whole life, but because of the 1035 exchange, it does not need to be the same policy for their whole life.
Not all 1035 exchanges are a good thing though, as all exchanges carry both advantages and disadvantages, as we will explore in the rest of this article.
When a 1035 Exchange Can Be A Good Idea
Most permanent life insurances provide two benefits - death benefit, which protects your loved ones, and living benefits, which helps you during your life as a safe haven investment vehicle.
Due to lack of access or conflicts of interests when people buy permanent life insurance policies, many end up with a policy that is not the most optimal to accomplish their goals as efficiently as possible.
Additionally, even though a policy might have been optimal when it was bought, it might have become less optimal over time, due to industry innovation and/or changes at the insurers that made the policy less efficient.
This means that many people who have bought policies in the past end up paying more than they should for their death benefit, or that they are getting less cash value growth than they could be getting with the money they are paying.
In these cases, doing a 1035 exchange could allow you to improve your returns from life insurance, or allow you to get better coverage for a lower price.
For indexed life insurance policies in particular, recent law changes made positive changes for their investment performance, which makes them especially likely to have potential for improvement in results through a 1035 exchange.
Keeping up with the most optimal policies in the industry can however be a daunting task - which is why our expert agents at White Swan offer a free insurance consultation to help you review your current policy and see if there are any better alternatives for you out there.
When a 1035 Exchange Might Not Be Good Idea
There are a couple of factors that could contribute to making certain 1035 exchanges a bad idea, which is important to look out for.
If your health has deteriorated since you bought your original policy, and your primary goal is life insurance coverage, the new policy could be issued to you with a lower health rating than your existing one, which could increase your costs.
There may also be surrender charges on your existing policy, which could erase any gains you would have gotten from exchanging your policy without the surrender charges.
Sometimes, lower prices for a certain amount of coverage can come with different, less attractive guarantees, lack certain benefits that your old insurance policy had, or be issued by an insurance company that is less financially stable and runs a higher risk of going out of business.
While it’s usually fine to transfer a loan on your old policy to your new policy, some carriers do not allow this, which might make the exchange cost you in taxes.
Additionally, due to conflicts of interest in the industry, some independent insurance agents can push their clients to do 1035 exchanges that benefit the agent, at the expense of the client, which might not always be obvious in the information made available to the client.
The best way to ensure that you don’t end up worse with a 1035 exchange is to take advantage of the free insurance consultation that is offered by our expert agents at White Swan.
Our agents are experts with decades in the industry, and have one goal only - to help you do a 1035 exchange if it will help you, and to not do a 1035 exchange if it will make you worse off.
If a 1035 exchange is not suitable for your case, there are other options that could potentially improve your existing policy, such as changing your plan with your existing insurance or getting a new complementary policy.
While 1035 exchanges can be a good idea to get better investment results from permanent life insurance or to get better coverage for a lower cost, they are not always a good idea.
To explore whether a 1035 exchange could help you, the safest way is to request a free insurance consultation from the expert agents at White Swan which will help you look for better alternatives and apply for a replacement policy if there are any better options.