The 1035 exchange is a tax-free transfer of cash values from one insurance contract to another. The exchange also carries the cost basis from the old contract to the new one. Functionally speaking, the 1035 exchange is a great strategy current life, endowment, and annuity policyholders can use to purchase a new policy with better features than their old policy while bringing over the value from the old policy with no tax consequences for making the change.
However, there are several important rules you must understand before you decide to replace an old insurance contract using the 1035 exchange. Ignoring these rules could result in unfavorable consequences leaving you worse off.
The Problem The Exchange Solves
Let's use an example to illustrate the problem that the 1035 solves for many insurance policyholders.
Old Insurance Policy with Lots of Cash Value
Kim owns an old whole life policy with $250,000 of cash value. She recently discovered that new whole life policies provide several benefits that her policy does not. She'd like to cancel her old policy and buy a new one, but her whole life policy's cash value exceeds her premiums paid by about $150,000.
If Kim cancels the old whole life policy, she'll have to add $150,000 to her income for the year and pay taxes on this additional $150,000.
Having to add the $150,000 gain in the whole life policy to her income, probably gives Kim serious pause and it certainly weighs against the benefits she achieves in the new whole life policy. The good news is, Kim can use the 1035 exchange to transfer all of the $250,000 cash value from her old policy to her new policy and owe zero taxes when doing this.
Additionally, the 1035 exchange will also transfer Kim's $100,000 cost basis over to the new whole life policy. Any premiums Kim pays to the new whole life policy will add to the existing $100,000 cost basis.
Sometimes, the desire to exchange an old policy for a new policy isn't about new features in a life insurance policy. Instead the goal could be to make use of the cash value through benefits found in other insurance contracts that have little or nothing to do with death benefit, such as annuity contracts. The 1035 exchange can also help these situations.
Transferring Life Insurance Cash to an Annuity
Michael has an indexed universal life insurance policy with $500,000 in accumulated cash value. He no longer needs the death benefit and he'd like an easy way to automatically create an income with the cash value he accumulated.
Michael looks at several annuity contracts and loves the idea of a guaranteed automatic income created by some of the annuity options he reviewed. But Michael has a $300,000 gain in his universal life insurance policy. If he cancels the policy and uses the cash surrender to buy the annuity, he'll owe taxes on an additional $300,000 of income.
Instead of canceling the policy for a full cash surrender and then using that money to purchase the annuity, Michael can use a 1035 exchange to transfer the $500,000 in the indexed universal life insurance policy to the annuity.
Doing this prevents Michael from having to pay taxes immediately on the $300,000 gain in the policy. Michael would owe taxes on income created by the annuity. However, Michael can also bring his cost basis over to the annuity.
This is significant if Michael chooses to annuitize the contract and take a guaranteed income from the insurance company. In this situation, the cost basis will allow Michael to use the exclusion ratio, which allows Michael to reduce his taxable income created by the annuity.
While the 1035 exchange is a powerful tool we often use to avoid taxes due when someone replaces an old insurance contract with a new one, there are several rules we have to follow in order to comply with laws that make a transfer tax free.
What Qualifies for a 1035 Exchange?
The rules that govern 1035 exchanges are very clear about which types of contracts a policyholder can replace his/her existing contract.
In the examples above we covered two such scenarios. One involving a life insurance contract to a life insurance contract transfer and the other involving a life insurance contract to an annuity contract transfer.
There are three types of insurance contracts that could be involved in a 1035 exchange; they are:
- Life Insurance
Please note that when I say endowment contracts I do not mean Modified Endowment Contracts. Endowment contracts, instead refer to a type of life insurance contract that was very popular prior to TEFRA/DEFRA laws that rendered them obsolete. So while you may not be able to buy a bona-fide endowment contract inside the United States any longer, many remain in force today from purchases made decades ago. Given this, I wanted to make sure everyone understands where and how these types of insurance contract fit into all of this.
I find it helpful to think of the permissible transfers from one type of contract to another using the above-ordered list, where 1 is highest in flexibility and 3 the lowest in flexibility. Let me explain.
You can 1035 exchange a life insurance policy to another life insurance contract, endowment contract, or an annuity. Life insurance contracts can transfer to any other type of insurance contract mentioned above.
You can transfer endowment contracts to another endowment contract or an annuity.
Lastly, you can transfer annuities to another annuity.
You cannot go backward, so for example you cannot transfer an annuity to a life insurance contract and do it as a tax-free 1035 exchange.
How Does the 1035 Exchange Process Work?
If you buy new life insurance (or an annuity) and plan to use a 1035 exchange to transfer money from an old contract to the new one, a few additional steps in the application process become necessary.
All life insurers have pretty standardized 1035 exchange paperwork that the agent/broker must fill out with the assistance of the policyholder. The form requires various information about the policy that the policyholder will replace upon completion of the exchange.
Additionally, the policyholder will need to assign the policy over to the new insurance company, which will allow the insurance company to discuss details of the policy with the old insurance company.
Despite having the assignment, there's a very good chance that the old insurance company will require the policyholder to sign a release permitting the old insurance company to disclose important details about the policy and/or release the funds from the old policy to the new insurance company.
The good news for the policyholder is that this process is more or less standardized among insurance companies and failure to complete appropriate paperwork results in little more than a delay in completing the transfer. It does not result in a failure to make the tax-free transfer. In other words, if you fill out paperwork incorrectly, you will not have to pay taxes on the transfer.
Important Tax Notifications After the Exchange Takes Place
Whenever a policyholder cancels an insurance contract the insurance company usually generates a 1099 and files it with the IRS. This has a lot to do with anti-money laundering protocol. The 1099 reports no taxable income, it's merely used to report distributions from a financial instrument.
The policyholder could, in some circumstances, also receive a 1099-INT that reports a nominal amount of taxable income to the policyholder. This most often happens when the old life insurer delays the release of funds from the old policy. Insurance laws often require the life insurer to act within a specific timeline or else pay the policyholder interest for the delay. Delays are common and payment of some small amount of interest often happens.
Once the new company approves the application for the new insurance contract, the insurer will make a request for the old funds from the old insurer. The old insurer will then send the funds to the new insurance company. The old insurance company will also send along important policy details like the recorded cost basis of the old policy.
1035 Exchange also Transfers Cost Basis
I already mentioned above that a 1035 exchange transfers the cash value tax-free to a new policy, but it also carries the old cost basis from the old insurance contract.
This means any premiums paid by the policyholder to the old contract will be credited as cost basis under the new insurance contract. This can have a few different strategic advantages.
More Capacity to Withdraw to Basis
Some income-producing strategies with life insurance involve a withdrawal to the cost basis before taking policy loans. Because life insurance benefits from using the First-in First-out accounting principle, the policyholder can recover his/her contributions to the contract before he/she must remove any gain from the policy.
Transferring the cost basis from the old contract to the new means the policyholder isn't forfeiting the ability to recover all the premiums paid to the old contract.
Minimizes Impact of Leaving at a Loss
Sometimes people make mistakes when they buy an insurance contract. Perhaps they fell prey to an extremely aggressive sales tactic. Perhaps they misunderstood the provisions of the policy. Or maybe they didn't really understand what they wanted until after the deal was done.
In any event, if someone owns an insurance contract that has yet to achieve a positive return and they discover that the current policy isn't what they wanted, using a 1035 exchange can at least carry what they did pay to the new policy. This is at times better than simply starting over with a new policy.
Maximizes the Exclusion Ratio
For annuity contract holders who choose to annuitize, the guaranteed income isn't entirely taxable. Annuities benefit from tax law that created the exclusion ratio. This is a calculation that makes only a portion of the annuity income taxable. The calculation is influenced by the amount of basis relative to gain in the policy. The higher the basis and therefore lower the gain, the less taxable income realized by each payment under the annuity.
Being able to transfer the cost basis can help reduce taxes on the income generated from some annuities.