1035 Exchange Considerations
First, what is a 1035 exchange? A 1035 exchange is similar to a 1031 exchange in real estate. It preserves the tax basis and the gains in a qualified life insurance or annuity contract to be moved to a new contract. What can I 1035 to?
A life insurance cash value policy can be "1035'd" to:
- Another life insurance policy
- A long term care policy
- An annuity contract
Note that an annuity cannot be "1035'd" to a life insurance contract. Life insurance can go to an annuity, but an annuity cannot go directly to a life insurance contract. Not without doing a withdrawal and then purchasing the life insurance policy.
When should a client consider doing a 1035 exchange?
When the insurance contract no longer fits their goals, either on the part of the client's situation OR the insurance company fundamentally changed the contract.
My perspective on 1035 exchanges:
Generally speaking, I'm not a fan of replacing policies, particularly cash value policies. Unless there are existing policies that no longer fits the client's objectives, then we can preserve those cash values to either a new life insurance contract or an annuity contract.
That being said, as of this date as I'm writing this (August 2nd, 2022), there is one particular company that is choosing to be "first to be worst". Here's the story: This company's cash value policies were originally structured and sold for retirement cash flow against their policies. In the process of demutualization, the company has made vast material changes to how they treat dividends than EVERY OTHER COMPANY. How? The company has now decided that "dividends are ONLY a return of unused premium and if you're not paying a premium, you're not getting any more dividend."
This is in direct contrast to what I had previously written about dividend treatment.
What is going to happen?
This company has demutualized. This means that the participating policyholders USED to participate in the profitability of the company through dividends. Policyholders have been compensated for their ownership interest and will no longer participate in that profitability.
That being said, the way they are choosing to treat existing policyholders who bought these contracts for a given reason... and they are choosing to abandon that premise as shown in their new in-force illustrations... it is going to cause a mass exodus.
Those who are healthy and insurable:
They will (more than likely) be doing a 1035 exchange to a new policy.
Those who are NOT insurable:
They will either stay put... OR consider doing a 1035 to an annuities (based on their goals and objectives).
Some additional considerations:
1) Age and health: Is the client still insurable? Does a new policy still make sense? When you're older, the new policy will have a higher premium or lower death benefit for the same premium. Does it still make sense? It can, but it needs to be verified.
2) Contestability in the event of death in the first two years restarts with the new policy. That just means that if death were to occur in the first two years of the policy, the causes and the application will be scrutinized to determine if there was a reason that the policy shouldn't have been issued or if they misstated the true nature of their health. If this was the case, then only premiums paid in would be refunded rather than the payment of proceeds of the policy.
3) The suicide clause also restarts on the new policy. Yes, life insurance can pay out in the event of suicide. However, suicide is only covered after the policy has been in force for two years. Why is this? Because it is believed that, even if one is suicidal when obtaining a policy, two years is a sufficient amount of time to obtain help and gain more mental strength and stability.
4) New acquisition costs in the policy. This is one of the biggest reasons to AVOID replacing a policy because of the built-in acquisition costs (including agent commissions).
This is where it can get interesting. If the policy is found to have changed or is different from what was originally promised (and I don't mean that dividends had a slight adjustment - I mean a REAL material change)... then comparing the cash values might not be the way to determine if you'll be better off or not. It might be that you look at what the policy can do for you for cash flow or other factors. Look at what you're trying to do and see if you'll be better off for making a change... or not. The cash values may be lower, but will your benefit be higher for making the change? Make that the factor to compare. So those are the things I'd take a look at. Again, I'm not a big fan of replacing cash value policies. However, sometimes you just have to do it to put the client in a better financial situation.