Is it Time to Recommend a 1035 to Your Client?

September 2, 2008

SOURCE: InsuranceNewsNet, Inc.

If an adviser’s clients have an insurance policy or annuity that no longer meets their needs, the advisor and clients may want to explore the idea of replacing that policy using the Section 1035 exchange.

The 1035 exchange is a provision in the tax code that makes it possible for investors to directly transfer funds inside a life insurance policy, endowment policy or annuity policy to another policy, without being taxed.

Unlike selling shares of stock to purchase another company’s shares where the profits are taxable, an annuity from one company can be exchanged for an annuity issued by another company with the earnings from the original investment still tax-deferred until withdrawals are made.
Under the current tax law, a 1035 exchange can be applied if it meets certain requirements. The owner and insured, or annuitant, on the new contract must be the same as under the old contract although changes in ownership can be made after the exchange is completed.

The contracts involved must be life insurance, endowment or annuity contracts issued by a life insurance company and only through the following exchanges:

• An old life insurance policy to a new life insurance policy contract
• An old annuity contract to a new annuity contract
• An old life insurance contract and a new annuity (but not an old annuity contract) to a new life insurance contract
• An old endowment contract to a new annuity contract

Exchanging more than one old contract for one new contract is also allowed. While the number of contracts that can be exchanged for one contract is unlimited, all contracts involved in the 1035 exchange must have all the same insureds and have the same owner. Any addition or removal of insureds on the new contract violates the tax law. For example, a client cannot exchange a single-life contract for a last-to-die contract or vice versa.
For some clients, a 1035 exchange can be a valuable method for replacing current contracts that are no longer appropriate because their needs and situations have changed over time.

There are many legitimate reasons why an advisor should recommend a 1035 exchange within a client’s retirement plan. For example, the client’s financial strategy has changed because his or her children are grown up and the life insurance policy bought as protection against premature death is no longer necessary.

A 1035 exchange may be also valid if products with better benefits and features become available in the market.

Annuity investors who are unhappy with the variable account in their contract can switch to another insurance carrier with a different annuity or investment options without tax implications.

Another reason to recommend a 1035 exchange is to preserve the adjusted basis of the policy that needs to be replaced. The adjusted basis is the total gross premiums paid less any dividends or partial surrenders received. Preserving the adjusted basis is important when the investor has a high cost basis in the old contract; that is, the old contract currently has a loss because the premiums paid are greater than dividends received.

Say a client holds a whole life policy that was purchased 15 years ago. After paying a $1,000 annual premium for the last 15 years, the client has received $5,000 in policy dividends. Currently, the policy has $6,000 in cash value. The client’s cost basis is 15 x $1,000 less $5,000 policy dividends or $10,000. The client wants a new policy with more protection and a lower premium.

Surrendering the old policy and using the $6,000 surrender value to purchase a new policy would result in only a $6,000 basis in the new policy. Through a 1035 exchange, however, the new policy will preserve the $10,000 cost basis of the old policy.

On the other hand, the 1035 exchange may not work if the client has an outstanding loan on his or her policy. Outstanding loans are recognized by the IRS when figuring policy gain. One way of exchanging a policy with an outstanding loan is to cancel the loan at the time of the exchange. However, cancellation of the loan on the old policy may still be considered a distribution and may be subject to tax.

In this case the client may have to pay off the policy loans first before making an exchange to avoid being taxed. This may present more disadvantages than advantages.

This can be avoided in the future by using products designed to carryover policy loans. One such product was recently launched by MetLife. This variable universal life policy has the ability to carry over outstanding loans to the new policy. This means clients may keep their policy loan on the old insurance contract while they exchange it for a new policy insuring the same person.

Advisors should also study if a 1035 exchange involving annuities might trigger any penalties or surrender charges. For instance, payments made under an immediate annuity contract for less than the life expectancy of a taxpayer who is under age 59½ is likely to be subject to the 10 percent penalty.

The IRC Section 72 includes conditions that may qualify your clients as an exception to the 10 percent penalty. These include:

• Payments which are made on or after the date on which the taxpayer becomes 59½
• Payments made for the joint life expectancies of the owner and his or her beneficiary or the life expectancy of the taxpayer and which are part of a series of substantially equal periodic payments

In addition, when the old annuity contract has matured past any surrender charges, exchanging it for a new annuity would likely mean a new surrender charge period. A good advisor should always take the time and practice due diligence to determine whether the new annuity contract’s features and interest rate justify the potential loss of flexibility for instant liquidity that the client is already qualified for in the old contract.

The 1035 exchange is one of the few tax laws that many professionals say is beneficial to investors. But experts also say 1035 exchanges should never be done frivolously. Advisors should first establish a valid reason for an exchange and then determine if such an exchange may have any unwanted side effects. If the coast is clear on every possible front, then an advisor can proceed forward confidently and carefully.

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