That old car has served you well, but it’s beginning to show its age. Not only does this venerable vehicle of yours no longer fit your needs, it can’t perform nearly as well as today’s automotive standard-bearers. So, sentiment aside, you realize it’s probably time to consider trading that aging ride in for one with the new bells and whistles you desire, or one that simply suits you and your lifestyle better than its outdated predecessor.
Trading in—and trading up—isn’t just for car owners. A similar concept applies to annuity and life insurance contracts in a process known as the 1035 exchange, which references the section of the tax code that allows the owner of a life insurance or annuity contract to trade in that contract for another without paying tax on the income and the investment gains earned on the original contract.
As with trading in one vehicle for another, there can be additional costs—such as surrender charges—associated with exchanging one contract for another. The benefits of a 1035 exchange therefore must outweigh those costs, according to advisors experienced with the process. The exchange should result in an upgrade for the contract holder, they say, whether in the form of a more tax-efficient estate/wealth transfer plan, more suitable and cost-efficient life insurance coverage, or guarantees that lock in the death benefit, a lifetime income stream or access to contract funds to cover long-term care costs.
Given today’s “do-more-with-less” mindset, the 1035 exchange is an important tool to consider as a means of maximizing the assets in a client’s portfolio, says John Freiburger, CLU, ChFC, CFP, principal at Partners Wealth Management in Naperville, Ill. “As crazy as the market has been, and is, clients are finally pulling their heads of the sand and realizing they need to have their money working for them as much as possible.”
While the 1035 exchange is a maneuver designed to benefit annuity and life insurance owners, advisors may profit as well, in the form of commissions they earn from the new contracts initiated on the back end of the trade-in process. Doing right by clients, while tapping that potential income source in the process, entails being able to zoom in on likely candidates for a 1035 exchange.
Typically, says Irwin Gross, RFC, CFS, AIF, a wealth coach at Family Wealth Partners in Weston, Fla., those candidates fall into several general categories:
- Someone whose life circumstances have changed, such as with the arrival (or impending arrival) of retirement, accompanied by a need to replace income.
- Someone whose family circumstances have changed, such as with the addition or loss of a spouse.
- Someone whose estate tax needs or priorities have changed, such as with a newfound desire to transfer wealth to heirs upon death.
Then it’s a matter of the advisor drilling deeper into the individual client’s circumstances to determine the suitability of a 1035 exchange. “You need to analyze that [life insurance or annuity] product,” says Freiburger, “to determine if it’s still serving its purpose, given the goals of the client.”
If it’s determined not to be, then a 1035 exchange (either full or partial) could be an option—as could surrendering the contract altogether or ultimately holding onto it because the benefits were determined not to outweigh the costs of the maneuver. “The main issues here are: What are the tax ramifications? What are the cost ramifications and what are the liquidity ramifications?” explains Gross.
When the shoes fits…
While the suitability of a 1035 exchange will always be dictated by a client’s needs, goals and circumstances, here are some scenarios in which trading in one annuity or life insurance contract for another may ultimately prove to be the best option:
When the client wants/needs less death benefit than the current policy provides. Perhaps guaranteed retirement income now has higher priority for a client than transferring wealth to heirs. Exchanging an old annuity for a newer one with a strong guaranteed lifetime withdrawal feature could be in order, says Freiburger.
When the client wants/needs a more robust death benefit. Other clients may decide they want to maximize their policy’s death benefit for wealth transfer purposes. Such a situation might then call for an exchange of one life product for another offering the strongest death benefit guarantees.
To access new kinds of features. “Getting some of the new bells and whistles—things like step-ups, bonuses and living benefits—is one of the main reasons you exchange an annuity,” Gross explains. “There is a cost attached to many of these features, but if they’re that important to the client, they can be worth it.”
Access to a new type of so-called “linked benefit” or “combination” annuity or life insurance product. These contracts come with a feature allowing the contract owner to withdraw funds on a tax-favored basis to cover long-term care costs.
To take advantage of today’s more favorable underwriting and mortality tables in order to reduce the cost of insurance. “Insurance carriers have definitely sharpened their pencils with their underwriting,” observes Freiburger, “meaning you might be able to get a better health rating, which is reflected in a lower cost of insurance.” The key consideration here, according to Gross: Over time, will the lower premiums from the new policy outweigh the cost of surrendering the old policy?
To streamline an insurance portfolio. One Freiburger client owned seven whole policies with more than $1 million in collective cash value. To cut insurance costs and simplify, Freiburger exchanged those policies for a single whole life contract.
To reduce portfolio risk and avoid volatility. Gross says he sometimes recommends that clients who are in or approaching retirement exchange an investment-oriented variable insurance contract (such as variable universal life) for a guaranteed UL product that offers more certainty with regard to cash value accumulation, death benefit and premium.
To maximize a wealth transfer plan. This can be done by exchanging an existing variable survivorship UL contract for a guaranteed survivorship UL contract and placing that new contract in a trust for heirs.
A Section 1035 exchange entails the direct assignment of one annuity or life insurance contract for another, without the contract-holder handling funds in the middle. The tax code provides for tax-free exchange from:
One life insurance contract to another life insurance contract;
A life insurance contract to an annuity contract;
One annuity contract to another annuity contract; and,
A life insurance or annuity contract to a long-term care insurance contract (via a partial 1035 exchange).
Exchanges of an annuity contract for a life insurance contract are prohibited.
Beware: the 1035 exchange process is governed by a host of rules and disclosure requirements that make it wise to consult a tax expert if necessary. For example:
If there’s an outstanding loan on the life contract being exchanged, the exchange could result in taxable income to the owner.
In cases involving a survivorship life insurance policy where one insured has died, that policy can be exchanged for a new one that applies only to the life of the surviving insured. However, a single life policy on one spouse may not be exchanged under Section 1035 for survivorship coverage on both spouses.
The rules that apply to the partial exchange of a life or annuity contract to fund a stand-alone LTCI policy also can be tricky.
Unlike with an IRA rollover, the taxpayer may not take custody of money from the old contract before applying it to the new one. The old insurance contract must be directly exchanged for a new contract.