A 1035 exchange on a life insurance policy is simply a rule that allows you to change your life insurance policy without incurring any taxes. It can be beneficial if you realize you need another policy type that works better for your changing financial goals. Below we’ll explore the concept of 1035 exchange life insurance and when it could work for you.
- What is 1035 Exchange Life Insurance?
- When Does It Make Sense to do a 1035 Exchange Life Insurance?
- When Should You Consider Surrendering the Policy Instead?
What is 1035 Exchange Life Insurance?
The term 1035 exchange life insurance comes from the fact that this is through Section 1035 of the U.S. Tax Code. Basically, through this section, if you exchange life insurance and annuity contracts in such a way that you see any gains, those gains are not recognized or taxed. You are still the owner of the policy and you cannot exchange with other people. The types of exchanges that are allowed include:
- A life insurance policy for another type of life insurance policy
- A life insurance policy for a nonqualified annuity
- A life insurance policy for a tax-qualified long-term care policy
- A life insurance policy for an endowment policy. Learn more about endowment policy here.
- An annuity for another type of annuity
- An annuity for a tax-qualified long-term care insurance policy
- An endowment policy for another type of endowment policy
In general, it’s important to note that an annuity cannot be exchanged with a life insurance policy under this section. This is to prevent people from exchanging policies to avoid taxation on an annuity’s gain.
According to FINRA, you must exchange the old policy for a new one. This is different from cancelling your current policy, receiving cash surrender value in a check, and using it to apply for a brand new policy. If you do that, and if your cash surrender value is more than all premiums that you have paid for the old policy, you have to pay income tax on the difference.
To make sure you are abiding by all current tax codes and exchanging the policy correctly, you should talk to your insurance agent.
When Does It Make Sense to do a 1035 Exchange Life Insurance?
Most people who are looking into a 1035 exchange life insurance do it because they find that another plan works better with their current financial goals. Some specific examples include:
- You might find a plan that has cheaper premiums, such as switching to a guaranteed universal life insurance policy, which offers fixed premiums and a death benefit for lower premiums than whole life insurance policy.
- You decide you want a policy that builds cash value better and have lower premiums, such as an indexed or variable universal life insurance plan. You might want to switch from your expensive whole life insurance policy.
When Should You Consider Surrendering the Policy Instead?
A drawback to the 1035 exchange life insurance process is that it is time-consuming. The process can often take months. Surrendering the policy can mean a faster return on surrender values if you qualify.
Market conditions may also affect if a 1035 exchange life insurance path is right for you. For instance, if the plan is linked to the markets and those markets are performing poorly, a surrender value may be less than all premiums you have paid. In such case, there is no economic benefit of an 1035 exchange life insurance.
Also, certain lifestyle changes can mean a life insurance policy makes less sense. For instance, if you are on an extremely fixed income and cannot afford to pay premiums going forward. Another common situation is if the family members you had the death benefit for passed away or are financially independent. Then you may want to just surrender the policy.
If there is an outstanding loan on the policy, you also may not be able to exchange the policy at all. You can either pay back the loan or reduce the original policy.
- 1035 exchange life insurance is a term that refers to exchanging policies in a way that does not incur taxes.
- Doing this makes sense if you find a life insurance policy that works better for you. These types of exchanges are usually done when you stand to make a gain in value and those gains would otherwise be taxed.
- It may make more sense to surrender the policy and get the surrender value if you are looking for fast access to the cash or the surrender value is more than the gains in the exchange. You should also consider surrendering the policy if your life has changed to the point of life insurance making less sense in the future, such as the passing away of a beneficiary.