What are 1035 exchanges and how do they work


Are you looking to exchange your current life insurance, endowment or annuity policy to a new policy you might consider 1035 Exchange
In this article we will discuss what 1035 exchanges are and when you should consider using them.

What Are 1035 Exchanges?

The so called 1035 exchange is a provision in the IRS tax code.

It allows you, as a policyholder, to transfer funds from a life insurance, endowment or annuity to a new policy and avoid paying taxes.

OK Cool, So How does a 1035 Exchange work?

Deferring The Gain

There will be no tax on the gain in the original policy at the time of exchange if

  • All the surrender proceeds from the original policy are transferred into the new policy
  • There are not outstanding loans on the original policy

If the policy is surrendered without a 1035 Exchange, the gain from the original life insurance contract will be taxed as ordinary income -not capital gains.

So What Is Gain?

Gain is the difference between the gross cash value of the contract at any time.

This includes any policy loans, and its premium tax basis. Premium tax basis is the amount placed in the contract less the premium for any additional benefits and also less any tax-free distributions.

No Gain?

The policy owner may still want to take advantage of the other tax benefits of a 1035 Exchange even if there is no gain in the original contract.

These benefits are not available if the original contract is simply surrendered.

Avoid Modified Endowment Status

If the subsequent premiums paid into the new policy, other than the exchange proceeds, are within the new 7-pay limit, then a 1035 Exchange of a life insurance policy allows the policy owner to place the original contract’s entire value in the new policy without creating a modified endowment contract, or MEC.

A modified endowment contract (MEC) is a tax qualification of a life insurance policy where the policy has been funded with more money than allowed under federal laws.
Preserve Basis

If the basis of the original contract is higher than its gross cash value, a 1035 Exchange allows the policy owner to carry over the higher basis into the new contract.

Generally, your basis is the amount of premiums you have paid into the policy less any dividends or withdrawals you have previously taken.

The original contract’s basis, which generally can be withdrawn tax-free, becomes the new contract’s basis, rather than the lesser amount actually placed in the new contract.

When is a 1035 Exchange appropriate?

By law all consultation on replacing an insurance policy must clearly be in the best interest of the policy owner.

After being fully informed about the advantages and disadvantages of the transaction, the policy owner should be the sole decision-maker. In addition existing insurance should never be terminated before the new policy is issued.

A replacement decision should be justifiable on either an economic or personal basis. The policy owner should consider the following

  • Implications of health changes. If the applicant’s health condition has changed since the application was taken on the existing coverage, the applicant may have to pay additional premiums or be denied coverage.
  • New contestable and suicide provisions on the replacement policy. The applicant needs to understand the possibility of a claim being denied under the new policy that would otherwise have been paid under the old policy.
  • Higher premium rate for the new coverage because of issuance at a higher attained age.
  • The impact of any surrender charges that may occur on the surrender of the existing policy
  • Differences in the way interest is credited to the new policy
  • Differences in policy provisions and guarantees.
  • Differences in additional benefits offered on the existing policy and the new policy.
  • Alternatives to replacement: change of plan with the existing insurer, additional coverage with the existing insurer, and repaying policy loans


When Should You Surrender A Policy And Not Do A 1035 Exchange?

You should consider the following regarding your current policy when deciding whether or not to use a 1035 exchange.

  • If on the existing contract, there is no gain or if there are loans outstanding that may represent a partial gain, there is no advantage to a 1035 Exchange.
  • The proceeds received in an exchange may be lower than in an immediate surrender if the existing policy is a variable or universal contract that contains a “market rate adjustment” provision,
  • A 1035 Exchange is more cumbersome and time consuming than a policy surrender. The timing is uncertain and the process can often take several months.

What Qualifies For 1035 Exchanges?

These are the “like-kind” exchanges that are candidates for a 1035 exchange

  • Life insurance for life insurance
  • Life insurance for endowment
  • Life insurance for non-qualified annuity
  • Endowment for endowment, with a maturity not later than the original endowment
  • Endowment for non-qualified annuity
  • Non-qualified annuity for non-qualified annuity

1035 Exchange Summary

1035 exchanges are a way that allows you, as a policyholder, to transfer funds from a life insurance, endowment or annuity to a new policy and avoid paying taxes.

1035 exchanges have advantages but may not be appropriate for your situation.

Always carefully weigh the implications of doing an exchange to see if doing one is fully to your advantage and always seek the advice of a qualified professional.

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