1035 Exchange: What It Is and How It Works?

KEY TAKEAWAYS

• A 1035 exchange is a tax-free exchange of an original contract for a new contract.
• The 1035 exchange is from Section 1035 of the Internal Revenue Code, which spells out the rules and regulations for these types of exchanges.
• Policyholders use 1035 exchanges to change their life insurance coverage without tax liability.
• When done correctly, a 1035 exchange can be a valuable tool for financial planning and estate planning.

What Is a 1035 Exchange?

A 1035 exchange is a tax-free exchange of one life insurance policy for another. This exchange allows you to change your life insurance coverage without having to recognize and pay taxes on any gains in the policy’s cash value.

How does a 1035 Exchange work?

In a 1035 Exchange, you can exchange one life insurance policy for another without having to pay taxes on the gain. This is because the 1035 Exchange is a “like-kind” exchange under IRS rules.

To do a 1035 Exchange, you must contact your life insurance company and let them know that you want to do an exchange. They will then send you a new policy that is similar to your old policy.

You will need to pay any fees associated with the new policy, but you will not have to pay taxes on the gain from the original contract.

When is a 1035 Exchange Appropriate?

There are a few key times when it might make sense to do a 1035 exchange. For example, you might want to consider a 1035 exchange if:

• You’re moving from one type of insurance product to another. I.E., from a traditional life insurance policy to a variable annuity contract. You cannot, as mentioned previously, exchange an annuity contract for a life insurance policy. 
• You’re upgrading your policy to one with better features or tax benefits
• You’re trying to consolidate multiple policies into one 
• You’re switching non-life insurance for life insurance
• You’re changing the beneficiary on your policy

It’s important to note that you can only do a 1035 exchange if you’re moving your money from one “qualified” insurance product to another. A non-qualified annuity doesn’t count. If you’re unsure about an annuity exchange, talk to your annuity company.

They can tell you about your surrender period and any tax consequences.

1035 Exchange Benefits

There are many benefits to completing a 1035 exchange, including:

1. Tax-Deferred Growth: When you invest in a new policy with a 1035 exchange, your money can continue to grow tax-deferred. This means you won’t have to pay taxes on any gains until you withdraw the money from the account.

2. No Penalties: If you need to access the cash value of your life insurance policy before age 59 ½, you would typically be subject to a 10% early withdrawal penalty. However, if you complete a 1035 exchange into another policy, you can avoid this penalty.

3. Maintenance Of Coverage: Do you have an existing life insurance policy that you no longer want or need? A 1035 exchange allows you to maintain your coverage without applying for a new policy. 

4. Avoidance Of Sales Charges: When you invest in a new life insurance policy, there are often significant sales charges associated with the purchase. However, these charges can be avoided if you use a 1035 exchange to move the money into the new policy.

5. Access To Different Types Of Products: A 1035 exchange gives you the ability to move your money into different types of life insurance policies. This additional benefit includes whole life, universal life, and annuities. This flexibility can be beneficial if your needs or circumstances have changed since you first purchased your policy.

Note that working with an experienced life insurance agent ensures you complete the process correctly. An agent can help you compare different policies and choose the one that best suits your needs.

1035 Exchange Pitfalls

The 1035 exchange is a powerful tool you can use to help you achieve your financial goals. But there are some potential pitfalls that you need to be aware of to make the most of it. Here are a few things to watch out for:

1. Not understanding the exchange rules: The 1035 exchange has a lot of rules and regulations that you need to be aware of before you start using it. If you don’t understand how it works, you could end up making costly mistakes that could jeopardize your financial security.

2. Not shopping around: There are a lot of different companies that offer 1035 exchanges, so it’s important to shop around and find the one that best suits your needs. Make sure to compare fees, investment options, and customer service before you make a decision. It is important to note that you may pay higher premiums of the new policy due to age or health changes. 

3. Investing too conservatively: Just because you’re using a 1035 exchange doesn’t mean you have to invest all of your money in cash equivalents. You can still invest in stocks, bonds, and other securities. But you need to make sure that you’re diversifying your portfolio so that you’re not putting all of your eggs in one basket.

4. Not monitoring your account: Once you’ve set up your 1035 exchange, it’s important to monitor it on a regular basis to make sure that everything is going according to plan. This includes reviewing your investment performance and making changes if necessary.

5. Taking too much risk: Just because you can exchange one investment for another doesn’t mean you should. You need to make sure that you’re only taking on as much risk as you’re comfortable with and that you have a solid plan in place to minimize your losses.

By following these tips, you can avoid the potential pitfalls of 1035 exchanges and use them to your advantage. Just make sure that you understand how they work before you get started.

Summary

A 1035 exchange is a great way to change your life insurance policy for one that is better suited to your needs. And you can do so without having to pay any taxes on the money you receive from the sale of your old policy. Moreover, you can use a 1035 exchange to trade-in your old life insurance policy for a new one or to get cash out of your policy.

There are some restrictions on what types of policies you can exchange. And there are also limits on how much money you can receive from the sale of your old policy. But if you’re looking for a way to do this without paying taxes, a 1035 exchange is definitely worth considering.

You will receive a 1099-R form report and 1035 exchange to another insurance company, however, it is not a taxable event.

Written by Sandra Habiger, CPA

Sandra Habiger is a Chartered Professional Accountant with a Bachelor’s Degree in Business Administration from the University of Washington. Sandra’s areas of focus include advising real estate agents, brokers, and investors. She supports small businesses in growing to their first six figures and beyond. Alongside her accounting practice, Sandra is a Money and Life Coach for women in business.

Written by Sandra Habiger, CPA

Sandra Habiger is a Chartered Professional Accountant with a Bachelor’s Degree in Business Administration from the University of Washington. Sandra’s areas of focus include advising real estate agents, brokers, and investors. She supports small businesses in growing to their first six figures and beyond. Alongside her accounting practice, Sandra is a Money and Life Coach for women in business.