Maximize the Efficiency of Your Insurance With a 1035 Exchange

Key Takeaways:

• Insurance protects your loved ones and helps you meet important financial goals. But policies can only help you if they are regularly reviewed to ensure they still meet your goals.
• Under the 1035 exchange provision, you can exchange your existing insurance policies without realizing a tax impact
• Work with an experienced professional to find out if the 1035 exchange is right for you.

Life is filled with consistent changes that rewrite financial goals. As you move through different life stages — getting married, having children, changing jobs or approaching retirement — your finances continue to evolve.

Over time, insurance policies may no longer align with your needs. That’s why it's important to reassess and adjust coverage.

In this article, we look at the benefits and key considerations when utilizing the 1035 exchange, which refers to a tax code provision that allows for the tax-free transfer of certain insurance policies. We explore how this powerful tool can help you update your insurance coverage, align your policy with your evolving needs and optimize your financial strategy.

What is a 1035 Exchange?

The 1035 exchange is a provision in the Internal Revenue Code. This provision allows for the tax-free exchange of select types of insurance contracts – such as life insurance policies, annuity contracts and long-term care insurance policies – to another “like kind” policy.

With a 1035 exchange, you can swap an existing life insurance policy for a new one with better benefits. You can also switch an annuity to one that better suits your current financial goals, without resulting in a tax liability.

The 1035 exchange is particularly helpful when you are looking to take advantage of improved policy features, lower premiums or updated coverage that aligns more closely with your evolving needs and life circumstances.

Benefits of a 1035 Exchange

The 1035 exchange offers a number of benefits to optimize your insurance portfolio without the burden of immediate tax consequences. Here are some key advantages:

1. Enjoy tax-deferred growth

With a 1035 exchange, you have the ability to transfer your existing policy's cash value into a new policy without triggering a taxable event. This means you can continue to grow your investment on a tax-deferred basis, allowing your assets to compound over time.

2. Enhance your policy features

Insurance products evolve, and newer policies often come with improved features and benefits. By utilizing a 1035 exchange, you can upgrade to a policy that offers better coverage, more favorable terms or additional options, such as riders for long-term care or disability.

3. Lower your premiums

If you've experienced changes in your health, or the insurance market has shifted, you may be able to benefit from lower premiums for the same or better coverage or offer a paid-up benefit. A 1035 exchange can help you take advantage of lower-priced opportunities, potentially saving you money on your insurance costs.

4. Better align with your current needs

As life changes, so do your insurance needs. For example, you may need a policy with a different death benefit structure, more flexible payout options or specific investment options within an annuity. The 1035 exchange allows you to select coverage that better suits your current financial situation and goals.

5. Consolidate your policies

If you have multiple insurance policies, a 1035 exchange offers an opportunity to consolidate coverage. Consolidation can simplify your financial planning, making it easier to manage your policies and align with your strategy.

Potential Pitfalls

To take full advantage of the 1035 exchange, it’s important to navigate around potential pitfalls.

For starters, updating your insurance policy may involve surrender charges. When you exchange an existing policy — especially if you’ve held it for a short amount of time — you may incur fees that reduce the financial benefits of the switch. Also, your new policy will likely come with its own surrender period, which limits liquidity. The surrender period prevents you from accessing funds without penalties, often for several years.

Another key consideration is the potential for higher costs or fees. When exchanging life insurance, a new underwriting may be required, which could result in higher premiums. While the exchange may unlock better coverage or benefits, new policies can also include increased administrative fees or added rider costs.

It’s also important to look at whether you’ll lose legacy benefits. Older policies often feature valuable guarantees, such as fixed growth rates or specific death benefits, that may not transfer to the new policy.

Lastly, if your current policy has an outstanding loan, the exchange could trigger an unexpected taxable event, reducing its value. To avoid this, consider paying off any loans before initiating the exchange, or work with a financial advisor to evaluate potential tax implications.

Requirements

Before you proceed with a 1035 exchange, pay close attention to the legal requirements outlined in Section 1035 of the Internal Revenue Code (IRC). Here are some key guidelines the IRS provides for 1035 exchanges, as of the time of writing:

Transfer process:

• Direct transfer only: The exchange must be a direct transfer between insurance companies. The policy owner cannot take constructive receipt of the funds at any point during the transaction, as this would trigger a taxable event.
• Full or partial exchanges: The IRS allows both full and partial exchanges, offering flexibility in how much of the current policy is exchanged.

Ownership and policy structure:

• Same policyholder: The owner of the original policy must remain the same for the new policy. For example, a joint policy cannot be exchanged for a single policy.
• Like-Kind policies: The exchange must involve “like-kind” policies. This means you must exchange life insurance for life insurance or an annuity for another annuity.

Eligible policies:

• Life insurance policies: Under current guidelines, you can exchange a life insurance contract for another life insurance contract, endowment or annuity contract. 
• Annuity policies: You can exchange a non-qualified annuity for another non-qualified annuity or a long-term care insurance contract. However, you cannot exchange an annuity policy for a life insurance policy.

Financial considerations:

• Policy basis: The original basis (the amount of money invested) remains the same in the new policy, ensuring tax deferral continues.

Tax reporting

• IRS Reporting: The exchange must be reported on your tax return, as required by the IRS.

Want to See if a 1035 Exchange is Right For You?

Speak with a Comerica Wealth Advisor today. Our team of wealth professionals would be happy to review your insurance policies and discuss whether the 1035 exchange is a good fit. To talk through your needs and identify next steps, contact Comerica.