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5 Guidelines for a Successful Section 1035 Exchange

Posted by BSMG on 12 Jan 2016

What Financial Advisors Need to Know

Often a policy review of your client’s existing life insurance and annuity contracts will conclude that a more cost efficient contract with better guarantees and/or rate of return is available. This may cause you to seek a potential transfer of the existing cash values to a new contract via a 1035 exchange.

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Internal Revenue Code Section 1035 provides an opportunity for non-taxable or “tax-free” exchanges between certain types of contracts under the concept of like-kind exchanges. 

Normally, when a life insurance policy or an annuity contract is surrendered, if the gross cash value of the contract exceeds the owner’s basis in the contract, gain is immediately taxed as ordinary income. However, when properly structured, Section 1035 provides that in some instances where the surrender proceeds from the original contract are transferred into a new contract, there will be no tax on gain at the time of the exchange. Taxation of the gain is not forgiven but rather delayed through the use of “carryover” basis since the income tax basis of the old contract carries over to the new contract. 

The IRC Section 1035 Exchange Requires Special Attention

IRC Section 1035 tax-free exchanges of life insurance and annuity contracts must be carefully handled to insure a smooth transfer of funds from the old carrier to the new carrier. 

Here are a few guidelines to keep in mind:

  1. If Contract Owner is the Same Before and After the Exchange
    1. Life insurance can be exchanged for life insurance
    2. Life insurance can be exchanged for an annuity. This includes exchanges to either a deferred annuity or a single premium immediate annuity (SPIA)
    3. A deferred annuity can be exchanged for another annuity. This includes exchanges to either another deferred annuity or a SPIA
    4. An annuity CANNOT be exchanged for life insurance.

  2. Types of Contracts that Can Be Exchanged
    1. Single life to single life
    2. Single life to single annuitant
    3. Survivorship life to survivorship life
    4. Survivorship life (one insured deceased) to single life
    5. Single annuitant to single annuitant

  3. Exchanges That Will Not Achieve a Tax-free Transfer
    1. Single annuitant to joint annuitant not related to the same insured(s)
    2. Single life to survivorship life not related to the same insured(s)

  4. Exchange of Life Insurance Policies with Loans
    1. You must be careful when exchanging policies with loans that are in a gain position - a policy is in a gain position if the total cash value is greater than the adjusted cost basis.
    2. If the loan is extinguished (discharged) on the exchange, the lesser of the loan or the gain in the policy will be taxable income to the policy owner. This will generate a Form 1099-R from the carrier.
    3. If the loan is carried over on the exchange to the new carrier, the exchange will be accomplished tax free. However, the new policy will be issued with an outstanding loan from the start. Many carriers have loan to value limits that must be met before they will accept a Section 1035 carry over loan.

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  5. Multiple Contract Exchanges
    1. Multiple policies with the same owner and the same insured can be exchanged for a new policy and one policy can be exchanged for multiple new policies. The cost basis of the contracts will be carried over to the new carrier and adjusted cumulatively (i.e. 2 for 1; 3 for 1) or proportionally (i.e. 1 for 2; 1 for 3) as the case may be.

When Is a 1035 Exchange Appropriate?

There are a number of reasons why a client might want to exchange an existing policy for a new policy. Some life insurance products offer features and benefits like guarantees against lapse or new policy riders providing chronic illness coverage that were not available just a few years ago. Furthermore, as a client’s family, business, and financial status change, the insurance purchased to meet objectives may need to be changed. In some cases, a new type of policy can solve a client’s need for insurance in a more cost-effective manner.  Where these factors exist, clients should be made aware of the opportunity and be given a chance to exchange the old policy for a new policy under Section 1035. 

However, not every policy exchange will be in the best interest of the client. The replacement of one policy for another must be considered carefully. There are a number of NON-tax factors that should be considered before suggesting an exchange. The non-tax factors that should be considered include:

  • New acquisition costs
  • Possible surrender penalties
  • Health status of the client

Additionally, clients should be made aware that there are important protections in an old policy, like the incontestable clause and the suicide clause for example, that are not immediately present in a new policy.

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The bottom line? Financial professionals should recommend replacement of existing life insurance ONLY when it is clearly in the best interest of the client. Of course, in addition to following the 1035 exchange process, appropriate replacement forms must also be completed.

Take caution with the paperwork to complete a Section 1035 exchange.

Carriers want the ownership to match exactly between the Section 1035 exchange form of the new carrier and the actual owner(s) of record with the old carrier. If this is not the case, the old carrier may not process the exchange until the “title” ownership matches exactly. This is especially important when existing policies owned by an Irrevocable Life Insurance Trust (ILIT) are being exchanged.

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Also, if a different policy owner is desired for the new policy, a change of ownership form must be executed. This change of ownership could take place either before or after the exchange depending on the specific facts of each case.

Contact a BSMG Life or Annuity Advisor when considering a Section 1035 exchange from one carrier to another carrier. A BSMG Advisor will work with BSMG Case Managers and BSMG Advanced Sales to ensure that the transfer of funds is handled in an expedited manner.

For more Advanced Sales topics, click here.

Topics: Advanced Markets