If you want to exchange your current life insurance, endowment, or annuity policy for a new policy, a 1035 Exchange just might be a great tax-deferred option for you to consider.
What is a Section 1035 Exchange?
1035 Exchange is the sale of a “qualified life annuity contract” (QLAC) in exchange for a qualified longevity annuity contract (QLAAC) or a qualified endowment contract (QEAC) in a Qualified Retirement Annuity Contract (QRAC) (both of which allow one or more death benefits to be passed on after the client dies). The current owner can usually access the money in the policy any time after the purchase is completed. If the owner needs to access the funds early, they can (subject to annual tax withholding). The account owner can’t use their gains to pay for living expenses while they are still alive. You can find more information in IRS Publication 590 (Circular 190) QLAC and QEACs allow you to defer up to $3,000 of gains each year on the sale of the policy.
How does a 1035 Exchange work?
Using a 1035 Exchange, you can complete the paperwork in conjunction with your insurance company, with a 1035 exchange form that can be completed in many different ways. In order to qualify for a 1035 Exchange, your current policy must have been purchased before 1993. Other conditions, such as being 25 years old or older, or having certain health conditions, may also prevent you from participating. In addition, any pre-existing conditions must be included in the 1035 Exchange.
When is a 1035 Exchange appropriate?
There are two situations when you might consider a 1035 Exchange: If you recently acquired a new life insurance policy, you can’t currently use it and don’t want to make a lapse of policy penalty when you change insurance coverage. If you are in the process of changing to another policy for the same reasons. There is no loss in cost to the government if you choose a 1035 Exchange, even if you’re in a higher tax bracket than the policy you are trading in. “Even in the current high-tax environment, a 1035 Exchange can provide tax benefits,” said Tim Dougherty, Senior Financial Planning Specialist at Raymond James & Associates in Denver. “The longer you hold on to the old policy, the more tax benefits you receive.”
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When is surrendering a policy better than doing a 1035 Exchange?
If you wait to surrender your existing life insurance policy to do a 1035 exchange, you’ll have to pay the gift tax (if you’re older than 59½) or you’ll have to file a 1041 Withholding Return. A 1031 exchange can also get you better tax-deferred treatment than a 1035 exchange. But waiting will also cost you more. The good news about surrendering to do a 1035 exchange is that you’ll usually avoid a penalty tax on the cash surrender value of the policy.
What are “like-kind” exchanges that qualify for 1035 Exchanges?
A like-kind exchange, or 1031 exchange, is one of the many ways to exchange real estate for something else, including stocks, bonds, commodities, foreign real estate, certain business interests, or cash. Keep in mind: The U.S. Treasury and Internal Revenue Service will not issue 1031 exchange applications on your behalf. If you are considering a 1031 exchange, you should work with a tax professional, independent broker-dealer, or other investment professional to make sure you do your homework.
Can multiple contracts be used for a 1035 Exchange?
You can generally only have one policy in a 1035 Exchange at any given time. It must be a life insurance policy, annuity or annuity contract, or endowment policy. It cannot be a long-term health plan or a deferred annuity. It cannot be a universal life or universal variable universal life policy. When can I use a 1035 Exchange? Once you sell your current life insurance policy, you may use your 1035 exchange to exchange your policy for a new policy. Generally, you must use your 1035 exchange before the life insurance policy expires.
Can the owner be changed during a tax-free 1035 Exchange?
Yes, the owner can be changed during a tax-free 1035 Exchange. This is called a non-forfeiture transfer. Yes, you can change your beneficiaries. (However, you may need to keep them current.) Yes, the owner can be changed during a tax-free 1035 exchange. When you obtain a life insurance policy with a named beneficiary, it’s irrevocable. That means your original named beneficiary cannot be changed for 1035 exchanges. Allowing you to exchange or change the owner in a tax-free 1035 exchange means that you can avoid making one of the following: Identifying a named beneficiary, Paying any premium on a newly issued policy, and Applying for the new policy.
Can the insured be changed during a tax-free 1035 Exchange?
Yes. The insured is always eligible to choose a new policy that would be immediately cash available for that beneficiary to take over. Yes. A 1035 Exchange does not change a person’s life insurance contract for any reason other than as permitted by law. The most common reasons that a life insurance policy would be swapped for a new one is when the insured dies or if the insured’s beneficiary changes. Any exchange is complete upon surrender.
Will the new life insurance policy become a modified endowment contract?
The fact that a policy exchange becomes a Modified Endowment Contract, however, can cause some confusion. Basically, the new policy is no longer a contract to ensure you have a certain amount of cash in your account on your death or disability and instead becomes a life insurance policy. This is just another type of life insurance policy that you buy and take out on yourself or on your beneficiary(s).
There are more than enough tax benefits from saving for retirement to negate the tax-free gain that a 1035 exchange can create. And that is an important distinction to make! It’s important that you always consider the tax consequences of any financial transaction and act accordingly. Not only are the current tax rules in your favor, but you can maximize your retirement savings by contributing to your 401(k) or IRA. It’s also important to note that you can also make a traditional IRA contribution in conjunction with your 401(k). That way, you can immediately deduct the pre-tax contribution that you make to your 401(k) from your current taxable income and only the post-tax contribution that you make to your 401(k) will be deductible from your taxable income.
“If you have any feedback about what is a 1035 exchange that you have tried out or any questions about the ones that I have recommended, please leave your comments below!”
NB: The purpose of this website is to provide a general understanding of personal finance, basic financial concepts, and information. It’s not intended to advise on tax, insurance, investment, or any product and service. Since each of us has our own unique situation, you should have all the appropriate information to understand and make the right decision to fit with your needs and your financial goals. I hope that you will succeed in building your financial future.