1035 Exchange Rules for Life Insurance / Should I Exchange my Policy?

Are you unhappy with the performance of either your current universal life or whole life insurance policy? Good news, you can use the IRS’s 1035 exchange rules for life insurance to your advantage. If you have accumulated excess cash values or have poor performing permanent policy, you can use a 1035 exchange to replace your current coverage with a new policy.

What is a 1035 Exchange? The IRS’s section 1035 exchange of life insurance falls under IRC section 1035.  A section 1035 exchange occurs when the cash in an existing life insurance policy is transferred to a new policy, without incurring any tax.

1035 Exchange Rules

The IRS has only three requirements or “1035 exchange rules” which must be followed in order for the 1035 transfer to be considered a tax free exchange.

  • IRC 1035 requires that the owner(s) of both policies are the same.
  • You never take direct possession of the money being transferred. So, your cash values must be directly transferred from one insurer to the other to be considered a tax free exchange.
  • Under section 1035, the new life insurance policy’s face amount is equal to or greater than your existing policy.

Who can Benefit from a Section 1035 Exchange?

The elimination of tax consequences opens up opportunities for you to save money. There are three common situations where a 1035 life insurance exchanges can help you:

  • Cash Rich Policy – Transferring the existing cash values from a cash rich policy towards paying down a new and improved life insurance policy.
  • Poor Performing Policy – Transferring the existing cash values from a poor performing policy for a lower guaranteed premium.
  • Company in Financial Trouble – For an insurance company, there is nothing more important than it’s financial strength and ability to pay claims to policyholders. If you have a significant cash value’s with a company with financial problems, it may be time to consider a safer option.

1035 Exchange

1035 Exchange on “Cash Rich” Policies

If cash value accumulation is also no longer a important, a new universal life policy can be used to replace your existing “cash rich” permanent life insurance. Since, life insurance companies keep your cash value upon your death, having excess cash value in your policy is pointless assuming you can qualify for a new policy.

A section 1035 exchange allows policyholders a fair way to exchange insurance policies. After all, you were allowed to grow the cash values in your old policy on a tax deferred basis. So, you should not have to suddenly have to pay taxes on this growth when you transfer a life insurance policy to another company.

Example: John has a $250,000 whole life policy, with $61,000 in excess cash value, and is paying $5,000 per year in premiums.

  • Following the 1035 exchange rules, he could transfer the $61,000 into a new $250,00 policy, with a new reduced premium of 3,000 per year or,
  • John could also exchange insurance polices, using the $61,000 to fund a new $400,000 policy with the same $5,000 premium.

1035 Exchange due to a “Poor Performance”

If you have an older flexible premium or adjustable life insurance policy which is not performing, you are not alone! Universal life insurance policies purchased decades ago did not feature a guaranteed premium. If interest rates changed the risk fell on the insured to make up the difference. Policies sold during this period of historic double-digit interest rates, are now crediting much lower interest rates.

As interest rates fell, insurers’ investment returns could not keep up with the premium projections. Now, policyholders are getting notices that their policies’ cash values are spiraling downward, which increases premiums and can cause policies to lapse or implode.

The good news is these policies can be rescued from their eventual demise. If your cash value is dwindling down, a new guaranteed universal life policy can be used to replace your existing “poor performing” policy. You simply transfer the existing cash values with a tax free exchange into a new and improved policy.

Example: John has a $250,000 universal life policy, with $61,000 of cash value. and he is paying a premium of $5,000 per year.

  • He find’s out from his insurance company that his overage will expire at age 82.
  • Following the 1035 exchange rules, John could transfer the $61,000 into a new $250,00 policy, and reduce his premium to $3,000, with a new guaranteed universal life policy until age 120.

1035 Exchange because of Financial Ratings

People often consider a section 1035 exchange when they are no longer comfortable with their existing carrier’s financial health. For an insurance company, there is nothing more important than it’s financial strength and ability to pay claims to policyholders.

If you are concerned about your current company, you can monitor the financial strength and claims paying ability of any life insurance company by using a number of different rating agencies.

Ratings agencies assist policyholders by assessing a grade based on the financial strength and claims paying ability of each insurance company. Each rating agency evaluates insurers slightly differently, but ratings are based on factors such as a company’s financial holdings and how much it is collecting in premiums compared with how much it’s paying out in claims.

If your company has been downgraded, we can look at alternative companies that offer higher ratings. Not to mention, insurance companies that are experiencing troubles financially typically try to find ways to cut costs.

One method to accomplish this is to lower the interest rates they crediting on your cash values. This can have a dramatic effect on how your policy performs over a longer period of time.

Example: John has a $250,000 universal life policy, with $61,000 of cash value. and he is paying a premium of $5,000 per year.

  • He learns that his insurance company is in financial trouble and is not comfortable staying with his company. He evaluates his policy, and finds the company has also lowered the interest rate on his cash value from 5% to the guaranteed minimum of 3%. Then, he realizes this will cause his coverage to lapse at age 78.
  • Following the 1035 exchange rules, John could transfer the $61,000 into a new $250,00 policy, and reduce his premium to $3,000. The insurance exchange would also allow John to guaranteed his coverage for life  with a new financially stable company.

What is a 1035 Exchange

Should you Exchange Insurance Policies?

Before you exchange insurance policies, we recommend contacting a life insurance specialist at Affordable Life USA to conduct a policy audit. A life insurance specialist is an agent familiar with many insurance policies and life insurance companies.

We use our life insurance calculator to conduct a detailed evaluation of how your current policy is performing.  Next, we provide a various comparison illustrations using your existing cash values towards funding a new policy. We conduct a two step process to find the best option available for you.

First, the specialist will work with your existing life insurance company to find a few details about your current policy:

  • How long will your life insurance policy last, assuming you keep paying the current premium,
  • How long will your life insurance policy last, assuming you stopped paying your premium?
  • What is your cash surrender value?

Secondly, a market evaluation will be conducted to determine if a newer policy could be more beneficial to you:

  • Determining if you can  qualify for new coverage: These policies are also medically underwritten, so it is important check into whether you can  qualify for coverage. First, your general medical history is initially evaluated to determine which company may be best suited for your particular medical history. Man carriers also require a brief insurance examination.
  • Evaluating all of the available coverage options: Then, illustrations will be generated on a new guaranteed premium policy from a competitive life insurance company using your existing cash values. Here are a few scenarios:
    1. Same Death Benefit and Lower Premium– Modern universal life policies can be purchased for the same death benefit while substantially lowering the premium.
    2. Same Death Benefit and No Premium – Depending on the cash surrender value available, the death benefit can also be designed with a death benefit that requires no  future premium payments (paid up policy).
    3. Smaller Death Benefit-If you do not have a lot of cash value, or your need for life insurance has changed, you might get by with a smaller face amount.
    4. Cash Out– Finally, illustrations will be generated on a new policy for the death benefit you require without using your existing policies cash value. You can surrender your old policy upon the approval of new coverage.

Now that you are aware of what is a 1035 exchange, you can certainly use it to your advantage. Keep in mind, the excess cash value sitting in your current policy does not benefit you. The only cash value required for your policy is the money needed to help pay the premiums until you eventually pass away.

Furthermore, if your policy is not performing or your company’s financial health scares you, you have a lemon! Why put more money on a dead horse. If you can qualify for new policy, the excess cash values can be used to exchange your insurance into a  universal life policy.

Affordable Life USA has experience following the 1035 exchange rules. We can exchange insurance for you by completing the required replacement form, 1035 exchange form, and designing a new illustration.

If you follow the 1035 exchange rules, you can directly transfer the money from your old policy into a new insurance contract. This strategy could lower your future premiums, and eliminate the potential taxes by surrendering your policy.

More importantly, the newer contract offers premiums and death benefits which are guaranteed not to change. If you would like assistance with your options, do not hesitate to call us, 1-877-249-1358.

Eric Van Haaften, LUTCF is the president of Affordable Life USA. We are a nationally licensed life insurance agency focused on finding our clients custom planning solutions at excellent prices. 1-877-249-1358. eric@affordablelifeusa.com