1035 Life Insurance Exchanges

Upgrading life insurance without tax penalties has become a more and more common goal. Responding to the changing needs of consumers, the life insurance industry has developed numerous exciting alternatives. These alternatives go much further toward satisfying a variety of financial needs and objectives than traditional types of insurance and annuities.

Increased flexibility available with 1035 Exchanges

Modern contracts offer much more financial flexibility than traditional alternatives. For example, universal life and variable universal life insurance policies allow you to adjust premiums and death benefits to suit your financial needs.

Modern contracts can also provide you with much more financial control. While traditional vehicles like whole life insurance and fixed annuities provide returns that are determined by the insurance company, newer alternatives enable you to make the choices that will determine your returns. For example, variable annuities and variable universal life insurance allow you to allocate your premiums among a variety of investment sub-accounts. These sub-accounts range from conservative choices such as fixed-interest and money market portfolios to more aggressive, growth-oriented portfolios. Your returns will be based on the performance of these sub-accounts.

Withdrawals made from a variable annuity prior to age 59½ may be subject to a 10 percent penalty. Generally, a surrender penalty will apply if the withdrawal is made during the early years of the policy. Variable annuity sub-accounts fluctuate with changes in market conditions. When surrendered, your principal may be worth more or less than the original amount invested.

There are many differences between variable- and fixed-insurance products. Variable universal life insurance offers several investment sub-accounts that invest in a portfolio of securities whose principal and rate of return fluctuate. Also, there are additional fees and charges associated with a variable universal life insurance policy that are not found in a whole life policy, such as management fees. Whole life insurance offers a fixed account, generally guaranteed by the issuing insurance company.

So what do you do if you’ve accumulated a substantial amount within your old life insurance policy or annuity and are ready to switch to another option? If you cash out your existing contracts and trade up to one that better suits your financial needs, you will have to pay income taxes on what you’ve saved.

Time for a 1035 Exchange

One solution to this problem is known as the "1035 exchange", found in Internal Revenue Code Section 1035. This provision allows you to exchange an existing insurance or annuity contract for a newer contract without having to pay taxes on the accumulation in your old contract. This way, you gain new opportunities for flexibility and tax-deferred accumulation without paying taxes on what you’ve already built up. However, there is one important restriction: you can only exchange in one direction, that is, from an annuity contract or a life insurance contract into a new annuity contract. You can not trade from an annuity back into a life insurance contract.

The rules governing 1035 exchanges are complex, and you may incur surrender charges from your "old" policy. In addition, you may be subject to new sales and surrender charges for the new policy. You’ll need the help of a financial professional. But it may be worth it. If you want to take advantage of today’s modern alternatives, consider a 1035 exchange.