What is a Life Insurance 1035 Exchange?

Section 1035 of the Internal Revenue Code deals with replacing a life insurance policy for a new one without incurring tax consequence for the exchange, in most situations. The IRS allows policyholders to do this in order to replace outdated contracts with new ones providing lower fees and improved benefits. Please consult your tax advisor for a full understanding as well as limitations and exclusions.

Compare Illustrations: Inforce vs proposed.

Remember that computer illustration you received when you first purchased the policy? It depicts policy performance from year to year and predicts how long you need to pay the premium. Next, ask your insurance company for a new illustration and how much longer you need to pay in premiums. Compare the two illustrations. Do you need to pay the premium longer than what was promised? After that, compare the latest illustration to what has been proposed.

Consider a Long Term Care Rider on the new policy.

It might make sense if it does not increase your proposed premium. There are Long Term Care Riders and there are also Chronic Illness Riders. Make sure you know which one is being proposed, because they work differently. See our tab on this website, "Should I Include a Long Term Care Rider?" just under the "What is it?" tab.

A 1099R will be sent to you at the end of the year.

A 1035(a) tax-free exchange may be tax free, but the IRS still requires this exchange to be reported. However, the 1099-R should show the taxable amount as $0 and distribution code of "6" (1035 exchange). For more information speak to your tax advisor or go to http://www.irs.gov/pub/irs-pdf/f1099r.pdf.

A new 2 year “Contestability Period” begins with the new policy.

One of the disadvantages of life insurance 1035 Exchange is that the contestability period, two years in most states, begins again. Remember, the old policy you have is most likely beyond that two year period. You will need to read each policy to see the specifics, but in general during the policy contestability period, the insurance company can contest or question the death claim by reviewing the original application for accuracy. Problems occur if information was omitted that would have caused the company not to issue the policy. For that reason it is very important that you complete the application as accurately and completely as possible.

Loans on the old policy? Can be a gotcha if not handled properly.

Be sure to review the policy you are considering replacing. Specifically, you may not even be aware that there is an outstanding loan. Loans can sneak up on people if they miss a premium payment or crediting rates are lower than expected. If the loan is not handled properly, you could realize taxable income when you do the exchange. Be careful and make sure your advisor has a thorough understanding of loans and "boot' rules.

Did you know: Most policies do not add Cash Value to the Death Benefit.

Sad, but true, most policies do not add the cash value to the insurance at death. Rather, the cash value is retained by the insurance company. Think you can access the cash value while you are alive? If the policy was designed with the lowest premium for the highest death benefit, (and most are) odds are, you can't. That type of design, generally builds up the minimal amount of cash value to keep the policy alive to a given age. If you do take a loan, it's likely the policy will lapse earlier than expected or require additional premiums. Not all policies work the same, however. It's possible you could merely pay principal and loan interest with good policy performance, but it all depends on the policy.