As life progresses, your needs evolve. Your and your family’s current situation might no longer align with your goals 20 years later. This can pose a challenge to long-term commitments like life insurance.
That’s where a 1035 exchange comes in. Instead of surrendering your old life insurance policy and starting over with a new one, a 1035 exchange allows you to transfer the policy’s value into a new one that works better with your life updates. Let’s explore this option in more detail.
What is a 1035 Exchange?
A 1035 exchange allows you to transfer your existing life insurance, annuities, or long-term care insurance policies to a new one without triggering income tax.
For example, if you have a term life insurance policy that no longer serves your needs—perhaps you’ve cleared your mortgage, or your kids are grown—you can exchange it for a new policy with updated benefits or lower premiums without penalties or taxes.
Rules and requirements of a 1035 exchange
- Policies that qualify for a 1035 exchange include life insurance, annuities, and long-term care insurance.
- The exchange must involve eligible contracts and be in-kind.
- The original policyholder must remain the same in the exchange process.
- You cannot cash out the contract or take any money from it during the exchange.
- The exchange must go directly from one institution to another to avoid income taxes.
5 Benefits of a 1035 Exchange
A 1035 exchange offers several benefits, including the ability to update your coverage without triggering capital gains taxes, reduce premiums, and improve policy terms.
1. You can upgrade your policy
A 1035 exchange lets you switch your old life insurance policy for a new one with better benefits. If your life or family situation changes, you can get a policy that fits your current needs without losing the money you’ve already paid.
2. Switch to a cheaper policy without paying taxes
You can trade your expensive life insurance for a cheaper policy and not have to pay taxes on any money you’ve earned in the policy. Simply transfer the value from the old policy to the new one, so it won’t trigger a taxable event.
3. Delay taxes on your earnings
With a 1035 exchange, you don’t pay taxes on the money your policy has earned until you take it out. Instead, those earnings continue to grow tax-deferred in the new policy or annuity. This allows your money’s value to compound over time without an immediate tax burden, preserving more of your funds for future growth.
4. Keep your original policy’s value
The exchange doesn’t make you lose the value you’ve built in your old policy. This means the money that has grown or accumulated in your old policy remains without needing to pay taxes. You only pay taxes later upon cashing out, which helps you avoid incurring liabilities.
5. Access better products and services
Insurance products are constantly improving, and exchanging policies allows you to upgrade to newer, better policies that offer lower fees, better coverage, or more benefits without the extra tax burden. It’s a great way to stay updated with the best insurance options for your needs.
5 Potential Pitfalls and Considerations Before Executing a 1035 Exchange
While the tax advantages can be appealing, several factors can affect a 1035 exchange’s overall value and suitability.
1. Higher costs might offset savings
Despite lower premiums, your new policy may have higher fees or other charges. These extra costs can cancel out the savings you were expecting.
2. Surrender charges can reduce value
When you exchange your old policy, you might have to pay surrender charges—fees for canceling your old policy early. Unfortunately, they can reduce the money to transfer into your new policy.
3. IRS complications can lead to tax issues
If you make a mistake while completing the exchange, like misreporting the transfer or not following IRS rules, the IRS may treat it as a taxable event. When that happens, you might end up with an unexpected tax bill on the gains from your old policy.
4. You may lose valuable policy features
When switching to a new policy, there’s a chance you’ll lose important benefits from your old one, like guaranteed death benefits or special riders. These features might not be available in the new policy, reducing its value for you.
5. Long-term commitment may create risks
A new policy can come with a “contestability period,” usually two years. During this time, if you make a claim, the insurance company may review it more carefully and possibly deny or delay payment if there were errors or omissions when you applied.
Strategies for Using a 1035 Exchange Effectively
You can get the most from a 1035 exchange by planning carefully and aligning it with your financial goals. Here are some tips for using this insurance option wisely:
1. Splitting benefits using partial 1035 exchanges
You can divide a single policy into multiple ones, giving you more flexibility. For instance, keep part of your coverage for life insurance while moving some value to an annuity for retirement income. This approach ensures your financial needs in different areas are covered while retaining tax benefits.
2. Converting life insurance to long-term care insurance
As you age, your priorities may shift toward covering potential costs like healthcare. With the policy exchange, you can upgrade to include long-term care benefits that make you eligible for financial support and death benefits at the same time.
3. Preserving cost basis for tax benefits
Transferring your old policy’s cost basis to a new one helps you avoid taxes on any earnings. This keeps more money in your pocket, especially if you need to liquidate your insurance funds.
4. Accessing better investment options
If your current policy no longer meets your needs, a 1035 exchange lets you switch to one with better features, like lower fees or more investment options, without triggering taxes.
Move Forward with Confidence
A 1035 exchange offers a unique opportunity to refine your financial strategy, but the key lies in taking action. Partnering with trusted advisors and aligning your policies with your future goals can ensure a smoother transition.
Your financial journey is always evolving—make sure your policies evolve with it. By working with the right experts, you can leverage the full potential of a 1035 exchange and achieve long-term financial success.
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Nick Carrigan
Nick trains and develops families in creating, maintaining, and growing wealth. This includes educating clients on the science and academics of investing, comprehensive financial planning, and ongoing coaching to ensure discipline for a lifetime. Nick has seen this create incredible levels of freedom, fulfillment, and love for the families he works with.
