Making a 1035 exchange

If you want to exchange your current life insurance, endowment or annuity policy to a new policy, a 1035 Exchange just might be a great tax-deferred option for you to consider.

What is a Section 1035 Exchange?

A 1035 exchange is a provision in the tax code which allows you, as a policyholder, to transfer funds from a life insurance, endowment or annuity to a new policy, without having to pay taxes.

How does a 1035 Exchange work?

Defer the gain: If all the surrender proceeds from the original policy are transferred into the new policy and there are not outstanding loans on the original policy, there will be no tax on the gain in the original policy at the time of exchange. If the policy is surrendered without a 1035 Exchange, the gain from the original life insurance contract will be taxed as ordinary income (not capital gains).

What is gain? Gain is the difference between the gross cash value of the contract at any time, including any policy loans, and its premium tax basis, which is the amount placed in the contract less the premium for any additional benefits and less any tax-free distributions.

What if there is no gain? Even if there is no gain in the original contract, the policy owner may still want to take advantage of the other tax benefits of a 1035 Exchange which are not available if the original contract is simply surrendered

Avoid Modified Endowment Status: If the subsequent premiums paid into the new policy, other than the exchange proceeds, are within the new 7-pay limit, then a 1035 Exchange of a life insurance policy allows the policy owner to place the original contract’s entire value in the new policy without creating a modified endowment contract, or MEC. This results in a policy with a higher initial cash value than would be the case if the original policy were simply surrendered and a new policy purchased

Preserve Basis: If the basis of the original contract is higher than its gross cash value, a 1035 Exchange allows the policy owner to carry over the higher basis into the new contract. The original contract’s basis, which generally can be withdrawn tax-free, becomes the new contract’s basis, rather than the lesser amount actually placed in the new contract.

When is a 1035 Exchange appropriate?

All consultation on replacing an insurance policy must clearly be in the best interest of the policy owner. The policy owner should be the sole decision-maker after being fully informed about the advantages and disadvantages of the transaction. Further, existing insurance should never be terminated before the new policy is issued. From the policy owner’s perspective, a replacement decision should be justifiable on either an economic or personal basis.

• Consider implications of health changes. If the applicant’s health condition has changed since the application was taken on the existing coverage, the applicant may be required to pay additional premium under the new policy or may be denied coverage.
• Consider implications of new contestable and suicide provisions on the new policy. This could result in a claim being denied under the new policy that would otherwise have been paid under the old policy.
• There may be a higher premium rate for the new coverage because of issuance at a higher attained age.
• Consider the impact of any surrender charges that may occur on the surrender of the existing policy - (AAFMAA policies do NOT have any surrender charges.)
• Consider any differences in the way interest is credited to the new policy.
• Consider any differences in policy provisions and guarantees.
• Consider any differences in additional benefits offered on the existing policy and the new policy.
• Consider alternatives to replacement: change of plan with the existing insurer, additional coverage with the existing insurer, and repaying policy loans.

When is surrendering a policy better than doing a 1035 Exchange?

If there is no gain on the existing contract, or if there are loans outstanding that may represent a partial gain, a 1035 Exchange would not offer an advantage.

If the existing policy is a variable or universal contract that contains a “market rate adjustment” provision, the proceeds received in an exchange may be lower than in an immediate surrender. This may depend on market conditions and the time it takes to process the exchange.

A 1035 Exchange is more cumbersome and time consuming than a policy surrender. The timing is uncertain and the process can often take several months. The policy owner’s intentions, the economic climate, and the financial condition of the current carrier can all be factors in the decision to effect a 1035 Exchange.

What are "like-kind" exchanges that qualify for 1035 Exchanges?

• Life insurance for life insurance
• Life insurance for endowment
• Life insurance for non-qualified annuity
• Endowment for endowment, with a maturity not later than the original endowment
• Endowment for non-qualified annuity
• Non-qualified annuity for non-qualified annuity

Can multiple contracts be used for a 1035 Exchange?

Multiple contracts can be exchanged for one contract, however, one contract may not be exchanged for multiple contracts.

Can a policy owner transfer part of the value of the exchanged life insurance proceeds
into the new contract and retain a part of the proceeds?

Any proceeds taken in cash, transferred into a non-like-kind contract, or used to extinguish a loan in the exchange are considered “boot” and will be taxed as ordinary income, to the extent of the gain in the contract or the amount of boot, whichever is less. This is less favorable than “basis first” taxation, which applied to life insurance distributions.

The policy owner can take a distribution from the original contract prior to the exchange and be taxed under the “basis first” tax rules, but caution is required. There is a risk that the withdrawal and the exchange could be considered a step transaction, in which case the cash distribution will be treated as “boot”.

What if there is an outstanding loan on the original life insurance contract?

Generally, the Association will not issue a new life insurance policy with an outstanding loan. There are several reasons why it is beneficial for a policy owner to repay a loan on a life insurance policy before the exchange:

• Any loan extinguished in the exchange is treated as a distribution from the original policy. The lesser of the loan extinguished or the gain in the contract will be taxed as ordinary income, so the exchange may not be completely tax-free.
• If a loan is extinguished in the exchange, the surrender proceeds will decrease by the amount of the loan. The new contract will accumulate more cash value with higher surrender proceeds, so the new contract will have the potential for higher accumulation if the loan were repaid prior to the exchange.
• If a loan is extinguished in the exchange, the amount of the original policy’s basis, which is carried over to the new policy, will decrease to the extent the loan exceeds the policy’s gain. Any reduction in the basis will increase the taxable amount of future distributions from the new policy.
• Endowment for endowment, with a maturity not later than the original endowment

What are the possible options if there is an outstanding loan on the original life insurance policy?

Pay Back the Loan. If the money is available, pay back the loan prior to the exchange.

Reduce the Original Policy. If paying off the loan is not feasible, it might be useful to reduce the original contract prior to the exchange.

CAUTION:

• The reduction cannot exceed the policy’s basis without incurring a tax.
• The reduction should take place within a reasonable period of time before the exchange to avoid a step transaction. The same amount taken in cash as part of a 1035 Exchange would be taxable to the extent of the gain in the contract.
• There may be forced out gain if the contract was issued after 1984 and the reduction is in the first 15 years of the contract.
• If the Association denies insurability, the applicant may not be able to restore the coverage lost in the reduction.

Can the owner be changed during a tax-free 1035 Exchange?

No, an ownership change is not allowed during a 1035 Exchange. There may be both income tax and gift tax consequences depending on the circumstances. If the policy owner wants the new policy to be owned by someone else, an option is to change the ownership prior to the exchange.

Can the insured be changed during a tax-free 1035 Exchange?

No, this is treated as a taxable exchange which is taxed in the same manner as a surrender of the original contract and the issuance of a new one.

Can a policy owner withdraw value from the new life insurance contract after the
exchange without a tax consequence?

If the new policy is life insurance and not a MEC, a loan can be taken from it without tax consequences. However, there is risk that the exchange and the subsequent loan could be considered a step transaction. The policy owner should wait a reasonable amount of time after issue of the new contract before taking a loan from it.

If the new policy is life insurance and the policy owner intends to make a partial surrender of the contract in the first 15 years, there could be a tax on the withdrawal even though the new policy is not a modified endowment and there is basis in excess of the distribution. Contracts issued after January 1, 1985 are subject to the forced out gain rule.

Will the new life insurance policy become a modified endowment contract?

The new life insurance policy will not be a MEC if the original contract is not a MEC and any new premium is within the adjusted 7-pay limit. However, if the original policy was a MEC, the new policy will also be a MEC. Once a MEC, always a MEC.

The 7-pay test for a 1035 Exchange computes how much of the new death benefit is theoretically paid-up by the exchange proceeds. This amount is subtracted from the total death benefit to arrive at the remaining unpaid portion of the death benefit. A 7-pay test is performed on this unpaid amount of insurance to determine the amount of “new money”, or money not part of the exchange proceeds, that can be paid into the contract each year. If the calculated amount is negative, then no new money may be paid into the contract.

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