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.
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.
Back to top
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 The original contract’s basis, which generally can be withdrawn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.
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.
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.
Multiple contracts can be exchanged for one contract, however, one contract may
not be exchanged for multiple contracts.
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”.
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:
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.
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.
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.
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.
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.
Get an Online
AAFMAA coverage is available up to $1,000,000 no matter what type of harm you may encounter.