We’ve decided there are a number of more elementary topics that we’ve not discussed here and in the interest of making the Insurance Pro Blog as great a resource as possible on the topic of insurance, we’re going to turn Friday’s into a day where we talk about more basic topics in the insurance and financial planning arena.
The 1035 exchange is a very fundamental subject with which pretty much any insurance agent or broker has a strong familiarity. It’s a foundational insurance license exam topic and most agents/brokers have handled a transaction or two involving this.
That’s all well in good, but what exactly are they, and what practical use do they bring to the table? Are there additional considerations about this often go overlooked? And when is it best to ignore it?
The 1035 exchange is an exchange between insurance products that must meet a certain criteria in order to qualify for the benefits afforded by the exchange. For the most part, these benefits have to do with the tax-free nature of the exchange, but we’ll learn later on that there are some additional benefits that can be mighty helpful.
The criteria for the exchange is mostly concerned with what type of contract we are exchanging. There’s a “flow” if you will regarding what can be into what. It’s easiest to think about as a sort of hierarchy of what can be exchanged into what.
At the top of the hierarchy is life insurance, followed by endowment contracts (Note: not Modified Endowment Contracts, but rather the really cool insurance contracts that were rendered useless thanks to our friends of the 98th Congress who passed the Deficit Reduction Act of 1984), and then lastly annuities. Exchanges can flow down the list, but not up.
This means that a life insurance contract can be exchanged to another life insurance contract, an endowment contract (if they still existed), and/or an annuity. But an annuity contract, on the other hand, can only be exchanged for another annuity contract and not for a life insurance contract or endowment contract.
There is some additional criteria that often goes overlooked, but for accuracies sake we should mention that the insured of the old contract must be the insured under the new contract. Meaning mom and dad can’t own a policy on son #1 and decide they’d rather have a policy on mom and 1035 the life insurance policy on son #1 to a policy where mom is now the insured. On annuity contracts, this will depend on if the contract is an annuitant or owner driven contract (we talked about this a while ago here, if you’re fuzzy on the details).
Primarily the 1035 exchange accomplishes a tax free transfer of the money in one insurance contract to another—real estate gurus and swap aficionados you can think of this similarly to 1031 exchanges, though not entirely the same.
This means, we can transfer the cash value of one policy to another policy without having to realize the gain in the policy as ordinary income and incurring an income tax liability. This has a multitude of applications to it:
And there are more applications.
The other thing that this accomplishes is a transfer of the old policy’s cost basis to the new policy. This has a few very useful applications from a tax mitigation point of view.
First and foremost, it allows more money to flow into the contract than the would be allowed to comply with modified endowment contract restrictions. This can also help on a the universal life side to bring the death benefit even lower than would normally be allowed under the guideline premium test.
But even more useful is the fact that we’re carrying the basis and not forfeiting credits for money paid into a contract. Take for example a person who purchased a really badly designed life insurance policy, and later finds out that a more efficiently designed whole life or universal life policy performs way better. Using this will maintain the basis of the old policy, so the new policy has a higher basis, leaving more room for a withdrawal to basic strategy.
Also, take an example where someone owns a life insurance contract that they’d rather transfer to an annuity and use the income benefit. Imagine further that this income benefits involves annuitization. Because the money is non-qualified, the annuitized income will take advantage of the exclusion ratio. And because of the transfer of the cost basis, this potentially means the exclusions ratio will make more of the income tax-free return of basis than normally would be the case. Or, if there is no gain on the policy, the exchange can make withdrawals from a non-annuitized contract a tax-free event.
This one is certainly a case-by-case consideration. For the most part, there are no rules of thumb, and it’s likely best not to forgo. Still, there are some agents/brokers who understand that the exchange process takes longer than typical new business, and might up to suggest that it can be skipped, approach with caution. Based on the numerous benefits it generally inadvisable to skip the benefits afforded by it.
Brandon launched the Insurance Pro Blog in July of 2011 as a project to de-mystify the life insurance industry. A specialist in the design and application of life insurance cash accumulation features, Brandon is one of the foremost authorities on the subject of coordinating life insurance cash values in a financial plan.