Section 1035 Exchanges for Life Changing Situations

A recommended annual review of your financial plan may reveal good reasons to make changes to your insurance coverage and annuity investments, including the replacement of existing policies.  These reasons can range from a change in the financial stability of your present carrier to changes in your financial goals or your personal situation.

Personal reasons can include a divorce or death of a spouse, or you may wish to take advantage of lower rates now available because of a change in mortality tables.  Perhaps you’ve changed your lifestyle and your improved health risk warrants a lower premium than you originally qualified for.

Because simply cashing out life insurance and annuities can result in large lump sum distributions triggering a substantial tax liability, consider using a tax-free exchange under Section 1035.

Section 1035 allows a policyholder to transfer into new policies while still retaining the original tax basis of the older policy and deferring any gains made since its inception, provided certain guidelines are followed.  In the case of life insurance, the new policy must be on the same person.  In the case of an annuity, the annuity must be payable to the same person as in the original contract.

Section 1035 can also be used to exchange a life insurance policy for an annuity policy, with the stipulation that the annuity must be payable to the person insured under the life insurance policy.  This is a useful tool in the case of a life insurance policy that has outlived its purpose.

Consider the following example:

Mr. Smith purchased a whole life policy as a young man, with the intent of protecting his family in the event of a premature death.  Thankfully, he’s lived to retirement age, and his children are now grown and doing well, so he’d like to use the accumulated funds to help produce income for his retirement.  Rather than cashing out the policy and taking an immediate hit on the taxable gains, the policy can be converted to an annuity under Section 1035.  The exchange does two things for Mr. Smith:  It provides an additional boost to his retirement income and allows the taxes on his gains to be spread out over the life of the annuity payments.

Summing it up, should it become necessary or beneficial to alter your insurance coverage or annuity contracts, the use of a Section 1035 exchange can result in significant savings for the policyholder.