One of the provisions of the Revenue Code that is very attractive to life and annuity policyholders is Section 1035. This provision of the Code allows you to transfer the values from a life policy or an annuity to a new contract and defer taxes on your gain. Life policy values may be transferred to a new life policy or a non-qualified annuity. A non-qualified annuity may also be transferred to another non-qualified annuity, but annuity values may not be transferred to a life policy.

A great benefit in this provision of the Code is that gains in the contract are able to be deferred, along with preserving cost basis if premiums paid exceed the cash value.
If there is a significant difference between the cost basis and cash value, it can be very valuable in retirement planning.

There are restrictions in 1035 Exchange plans people should be aware of:
– The insured may not be changed in a 1035 Exchange. If the insured changes, a taxable event will incur as if the contract had been surrendered.
– Likewise, policy ownership may not be changed. There could be not only income tax liability, but potentially Gift Tax consequences.
– It is important that a person not receive a check for the fund transfer as that can also generate a taxable event. The funds must go directly from the prior carrier to the new carrier.
– While it is permissible to combine multiple policies into a new contract, multiple policies in a 1035 Exchange may not be issued.
There are several reasons to exchange an existing life policy including:
– Reduced rates from new mortality tables.
– Improved product design or features and benefits not available in the old policy.
– The current policy may have been underfunded so badly it mathematically cannot be rescued.
– The current carrier may be in financial trouble or you may have become an “orphan” policyholder with no servicing agent.

Likewise, there are several scenarios that probably make a 1035 Exchange a bad idea:
– Your insurability is doubtful.
– There are significant surrender charges, particularly in the annuity.
– The proposal for a new life policy utilizes existing cash values for a very large face amount with high renewal premiums that cannot be paid.
– The new carrier doesn’t properly address outstanding policy loans in the old policy.

If you have older life policies and are insurable it’s not a bad idea to take a look at a newer model. There are significant improvements available in annuities if the surrender charges are manageable. Regarding variable life and annuities, it’s certainly worthwhile to have them reviewed. Fees and charges may have increased while some of the investment options and programs may no longer be available.

In my next article, I will outline a few examples of 1035 Exchanges in specific situations.