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Financial Advisors: Should You Use a 1035 Exchange to Optimize Life Insurance?

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    Life insurance is a long-term asset. Over the decades a life insurance policy is in force, your client’s financial situation is likely to evolve. Sometimes, that evolution is so significant that the existing life coverage is no longer a good fit.

    When that happens, your client will look to you for a recommendation on how to optimize their coverage cost effectively. One option to discuss is the 1035 exchange. To prep for those conversations, here’s a closer look at how 1035 exchanges work, their advantages and disadvantages, and alternative strategies to consider. 

     

    What is a 1035 exchange on a life insurance policy? 

    A 1035 exchange is a tax-free method for replacing an existing life insurance policy.  The number 1035 refers to the section of the tax code that defines and allows for this transaction. 

     

    How 1035 exchanges work 

    Typically, cashing out a life insurance policy is taxable if the proceeds are more than the client’s cost basis. Any tax liability, of course, lowers the client’s budget for new coverage. The 1035 exchange waives the normal tax consequences, but under strict guidelines. A few 1035 exchange rules are:  

    • The owner and the insured on the new policy must match the owner and insured on the old policy.
    • The policyowner cannot take possession of the proceeds from the old policy — the life insurer(s) must handle the transfer. 
    • If the old contract is life insurance, the new contract must also be life insurance. This is important to point out because Section 1035 exchanges can also be used for annuities. In that case, the exchange must be from one annuity to another annuity — not from life insurance to annuity or vice versa. 

    For the client who does qualify for the exchange, any gain in the old insurance policy gets transferred to the new policy. If the client later cashes out the new policy, there may be tax consequences.

     

    Who needs a 1035 exchange?

    A section 1035 exchange is for the life insurance policyowner who wants to update coverage but has a taxable gain in an existing policy. If the client’s surrender value of the existing policy doesn’t exceed the total premium payments, there’s no taxable gain. In that case, a 1035 exchange isn’t needed.

     

    Pros and cons of 1035 exchanges 

    Pros

    The primary advantage of doing a 1035 exchange is the tax deferral. Your client can secure a policy with more favorable terms, without incurring a big tax bill. 

    Cons

    A tax deferral on a sizable gain can be a huge advantage — but it doesn’t always outweigh the disadvantages of a 1035 exchange on life insurance. Potentially negative outcomes to consider include: 

    • Less efficient insurance premiums on the new policy due to age or health. An older life insurance policy, priced when your client was younger and healthier, is likely to have lower premiums. A new policy will consider your client’s current age, health, and lifespan (which dictates how many premium payments will be made going forward).
    • Surrender charges could reduce proceeds on the old policy. Surrender fees can be very high in the early years of the policy. Older policies may have low or no surrender fees.
    • First-year policy expenses, such as commissions, may consume the cash value in the old policy. Fees on a new policy can reduce the efficiency of the 1035 exchange.
    • 1035 exchanges get more complicated if there is an outstanding policy loan. Completing a 1035 exchange on a policy with an outstanding loan is called a loan rescue. Not all insurance carriers do loan rescues. If a client does a 1035 exchange and the policy loan isn’t transferred in full, the unpaid balance is probably taxable.

      Your client may want to pay down the loan prior to the exchange to avoid those complications. Alternatively, the client could reduce the size of the policy to offset the loan the balance. This strategy should be handled carefully, however. The IRS may view the policy reduction and the exchange as a single transaction, even if they happen in two separate steps. In that case, the loan balance may still be taxable. To avoid that outcome, several months should separate the reduction and the exchange.    

     

    Alternatives to a 1035 exchange 

    Based on your client’s situation, the 1035 exchange may not be the ideal solution. Fortunately, there are other ways for policyholders to upgrade or modify their insurance coverage. Three alternatives are a life settlement, purchasing a new policy and keeping the old one, or surrendering and replacing the life insurance outside of a 1035 exchange.  

    1. Life settlement 

    A life settlement is the sale of life insurance to a third-party for a lump sum of cash. Policyholders who are 65 or older usually qualify, as long as the policy is valued at $50,000 or more. 

    The life settlement is not a tax-free transaction. The portion of life settlement proceeds that represents a gain is usually taxable. 

    Still, the life settlement can be an attractive alternative to a 1035 exchange. This is because the sale price will be much higher than the policy’s surrender value. Often, life insurance will sell for two to four times more than its surrender value, or up to 60% of the death benefit. Net of taxes, that may leave your client with more cash to spend on new coverage. 

    If the net cash proceeds are more than what’s needed to buy replacement coverage, your client can spend or save the extra cash. There are no restrictions on how those proceeds are used.

    Also, since there’s no tax deferral on a life settlement, any new coverage the client purchases won’t inherit the taxable gain from the old policy.

    2. Purchase additional insurance 

    The client who needs additional life insurance could also purchase supplemental coverage and keep the old policy in force. This can be more cost-efficient than exchanging a smaller policy for a larger one. 

    If the new premiums are higher because the policyowner is older, for example, it makes sense to keep the existing policy. That way, the higher premiums only apply to a portion of the client’s overall coverage. 

    3. Surrender and replace without a 1035 exchange 

    When there’s no taxable gain hiding in the client’s existing life insurance, there’s no need to do a 1035 transfer. The client instead could surrender the old policy and buy a new one, with no tax consequences. 

    Before moving forward on this strategy, compare the potential after-tax proceeds from a life settlement to the existing policy’s surrender value. If the life settlement is more lucrative — and often, it is — then a surrender probably isn’t the right option. 

    You can learn more about the pros and cons of life settlements at HarborLifeSettlements.com. Our team offers free life insurance appraisals. The value of your client’s life insurance on the secondary market is a key consideration when evaluating a 1035 exchange. If the client can come away with more cash through a life settlement, your client may prefer that strategy over a 1035 exchange. 

    Reach out to Harbor Life Settlements today to learn more.

    Catherine Brock

    Catherine Brock

    Catherine Brock is a personal finance writer who's been featured in The Motley Fool, Refinery29, Wellness.com and has made appearances on ABC7 Chicago, FOX2News St. Louis, KCAL9 Los Angeles, Fox19 Cincinnati, WGN TV Chicago and WCPO TV Cincinnati. When she's not writing, she can be found riding a horse in the country or shopping online for clothes.

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    Harbor Life Settlements Will Help You Get The Most Money For Your Life Insurance Policy