With retirement nearing, Steve Parrish no longer needed the whole life policy he’d owned for 25 years. The St. Augustine, Fla.-based attorney and co-director of The American College of Financial Services’ Center for Retirement Income, where he is also an adjunct professor of advanced planning, figured a single premium immediate annuity was better suited to his current situation.
“My planning needs had transitioned from protection to retirement income,” he explained.
If he sold off the life insurance, however, he’d owe taxes on the gains it had incurred over the past quarter-century. So, instead, he employed what’s called a “1035 exchange.”
Here’s how it works:
The Nuts And Bolts
Under Section 1035 of the Internal Revenue Service code, certain insurance contracts can be exchanged for others without generating taxes.
Specifically, a life insurance policy can be exchanged tax-free for another life insurance policy, an annuity, or a long-term care (LTC) policy—either the traditional, standalone variety or a hybrid plan that’s linked to life insurance or an annuity. In all cases, the owner and insured person must remain the same.
In addition, a nonqualified annuity can be traded tax-free for another nonqualified annuity or for either kind of LTC plan. Again, there can be no change of ownership. Annuities cannot be exchanged for life insurance in this way.
Also, LTC coverage can be swapped tax-free for an annuity but not for life insurance.
Lastly, an endowment contract can be exchanged tax-free for another of like kind.
All transfers must be direct. You cannot receive cash, even if it immediately goes to buying a new insurance product.
Full Or Partial
But you don’t have to jettison the entirety of the old policy. “Most clients think of this as an all-or-nothing type of scenario. It isn’t,” said Robert Peterson, senior wealth advisor at Crescent Grove Advisors in Lake Forest, Ill.
You could, for instance, replace only a portion of a life policy’s value, or transfer out chunks at a time as your needs change. “This may be appropriate if there are still valid benefits of the original contract, but things have changed for the client and they may not need the same benefits they originally intended,” he said.
Partial transfers can also help with funding LTC policies, which typically require annual premiums rather than a single upfront payment. You can do a partial 1035 exchange every year when the LTC premium comes due.
For future tax purposes, the cost basis of the original contract carries over to the new one. So if the original policy or annuity cost $100,000, say, and there were no loans or withdrawals, that will remain the official cost basis of the new contract, even if the old contract changed value and that’s not the actual amount transferred. (For partial exchanges, only a portion of the cost basis is assigned to the new product.)
Reasons to consider making a 1035 exchange
Recent increases in interest rates have created some good reasons for considering a 1035 exchange. “Insurance companies have benefited greatly from the rising interest rate environment and can now create products with richer benefits compared to what they could do when rates were near 0%,” said Jonathan Barth, regional vice president at DPL Financial Partners in Louisville, Ky.
Some insurance companies have also updated their life expectancy tables, said Robert Lickwar, a managing director at UHY Advisors in Farmington, Conn. Longer life expectancies “could result in lower annual premiums for the same amount of insurance, or a higher death benefit with the same premiums,” he said.
Another good reason to consider an exchange is if you’ve come to doubt the reliability of the original company or sales agent.
Yet for many others, it’s simply that their reasons for buying the original policy are no longer valid. “Unforeseen events such as the death of a spouse, a major medical issue, etc., may require adjustments to a retirement plan and the products that support it,” said Todd Giesing, assistant vice president of LIMRA Annuity Research in Windsor, Conn.
Clients might have purchased an annuity with an income rider, say, “because they were unsure of their future income streams,” said Brett Larocque, an advisor at Alera Group’s Johnson Brunetti in Weathersfield, Conn. “As time passed, they noticed their cost of living was not as substantial [as expected], and the fixed income stream was no longer required.” They might now prefer an annuity that’s geared to asset accumulation, to leave a bigger legacy for heirs.
Another possibility is that, with age, the client has become concerned about LTC expenses. If so, there is “an interesting quirk” to the rules, said Mike Padawer, founder and president of INERTIA / Advisor Services Group in Clearwater, Fla.
When exchanging life insurance or an annuity for an LTC policy, the policy owner can actually add a spouse as the primary beneficiary if the insurance company allows it. This, he said, “effectively turns a single-life [contract] into a joint-life LTC plan.”
What’s more, because LTC insurance has no cash value, and LTC benefits are paid tax-free, switching an annuity or life insurance contract to LTC coverage completely eliminates any taxes that would’ve been due on gains in the original product.
Arguments Against Making A 1035 Exchange
Despite the benefits, experts have many caveats about these exchanges.
“If the old [life] policy was issued when the insured was far healthier, the new contract could be a bad idea simply because age and health will increase the new premiums,” said Parrish, adding that the reverse is also true. If you bought a life policy after a health scare and are actually in better shape now than you were then, a new policy might offer lower premiums.
Be warned, too, that the cash value of the original policy might be diminished to pay upfront costs of the new policy. Furthermore, many life policies and annuities charge a fee for surrendering them before a certain period of time has passed. Such surrender charges will be taken out before any funds are transferred. The new policy or annuity may have its own surrender period as well, potentially locking you in for even longer.
A “more insidious challenge,” said Parrish, is if you’ve borrowed against the original life insurance. The loan amount will be taken out of the exchange and might count as taxable income, he said.
For some annuities, the trade-in value may differ from what you expect due to “market value adjustments,” meaning the underlying assets—usually long-term bonds—have either appreciated or depreciated since the annuity was issued.
Whether to undertake a 1035 exchange is a question that should be explored at every client’s annual review. Exchanges should not be rushed into either. “A quality financial professional should educate and inform the client of all charges, fees, tax consequences, and other potential pitfalls,” said Lickwar at UHY Advisors. If there are any doubts, “consider obtaining a second opinion,” he said.
Parrish recommends asking both insurance companies—the old one and the new one—for an “in-force illustration” to project how each policy will perform going forward.
“Tread lightly,” added Crescent Grove’s Peterson, and be sure the exchange is solving a problem, not creating one.
Finally, realize that 1035 exchanges must be reported on a tax return.