A 1035 tax-free exchange may provide good options for tax liability management.
Named after Section 1035 of the Internal Revenue Code, a 1035 Exchange is the exchange of one insurance policy for a newer policy with no tax consequences. It offers an investor the opportunity to exchange an old, outdated insurance contract for a more modern contract that offers beneficial features the investor now wishes to include. For example, a policy owner might choose a contract with lower costs, a higher death benefit, the drawing of monthly installments, or different investment options.
A 1035 Exchange also offers tax advantages. Usually, the surrender of an insurance policy is taxable because the positive gain on the old contract is counted as income. However, a 1035 Exchange allows the nontaxable transfer of an old contract to a new contract, providing the IRS stipulations are met and the transaction is a direct exchange carried out between insurance companies.
A 1035 Exchange also preserves the adjusted basis of the original contract. The adjusted basis of a policy refers to the premiums that have been paid less any dividends or partial surrenders the policy owner has already received. Preserving the adjusted basis is advantageous to an investor when the original contract currently has a loss because its adjusted basis is more than its current cash value.
A 1035 Exchange applies only under certain conditions. , and only certain types of contracts can be exchanged: life insurance, endowments, and annuity contracts. An old life insurance policy can be exchanged for a new life insurance policy or a new annuity, an old endowment contract can be exchanged for a new annuity, and an old annuity can be exchanged for a new annuity.
Contract holders may exchange two or more old contracts for one new contract if the contracts belong to the same owner. Investors may also choose a Partial 1035 Exchange involving only a portion of the original contract’s amount, although any gain is subject to ordinary income taxes when withdrawn, and some insurance companies do not recognize partial 1035 Exchanges for tax reporting purposes.
The rules surrounding 1035 Exchanges are complex, and consultation with a tax professional is recommended. The cost and availability of insurance depend on factors such as age, health, and the type of contract. Make sure you are insurable before surrendering your old policy if you are updating a life policy. Contracts have limitations; make sure you fully understand the benefits and the limitations.