Financial planning often includes purchasing a life insurance policy to provide a source of income and financial security for surviving dependents.
While there are many different kinds of life insurance policies, two of the most common products are term life and whole life policies. Meanwhile, variable and variable universal life insurance policies, differ from their more commonplace counterparts in that the cash value of these policies is used to invest in a portfolio of securities chosen by the policyholder. These investments are held in accounts separate from the issuing company’s general assets.
These investments are a big piece of the insurance business -- life insurance, annuity cash investments, and separate account assets totaled $7.1 trillion in 2019, the Insurance Information Institute reports.¹ Since these policies have monetary value -- which can fluctuate depending on the performance of chosen investment options -- they are considered securities by the Financial Industry Regulatory Authority.
Policyholders can exchange their life insurance policies for another by completing a 1035 exchange. Below we look at how the 1035 exchange process works and how policyholders can avoid paying capital gains taxes when they exchange existing insurance policies for new ones.
How Does a 1035 Exchange Work?
With a 1035 exchange, policyholders can swap life insurance policies for new ones and avoid paying capital gains taxes on any proceeds that have been realized from their investments.
There are two caveats:
- The old policy must be directly exchanged for a new one -- you can’t cash out your existing policy and use those funds to purchase a new one.
- You can only make tax-free exchanges from one policy to another or to an annuity. The process doesn’t work in reverse -- you can’t do a 1035 exchange from an annuity into a life insurance policy.
Pros and Cons of 1035 Exchanges
Policyholders complete 1035 exchanges for a variety of reasons, including:
- Lower coverage costs
- Concerns about the solvency of the issuing insurer
- Adding new benefits or features
- Shedding underperforming investment options for more beneficial investment products
There can be some drawbacks as well, such as early termination penalties, higher premiums, and a contestability window if death happens within the first few years of the new policy being issued.
The Bottom Line
The 1035 exchange process is very similar to the more common 1031 exchange, wherein investors swap one investment property for another in order to defer paying capital gains and other taxes. There are strict rules and timelines that must be met in order to satisfy IRS requirements for a 1031 exchange. Investors often complete 1031 exchanges in an attempt to build wealth through different commercial real estate asset classes, or to diversify their real estate holdings and attempt to manage risk by purchasing assets in different geographical locations.
Similarly, 1035 exchangers must meet certain requirements. Consulting with qualified tax, insurance, and legal professionals can help ensure you meet those requirements if you are considering a 1035 exchange.
1. Facts + Statistics: Life Insurance, Investments, Insurance Information Institute, https://www.iii.org/fact-statistic/facts-statistics-life-insurance
Should You Exchange Your Life Insurance Policy? FINRA, https://www.finra.org/investors/alerts/should-you-exchange-your-life-insurance-policy
1035 Exchange, American Armed Forces Mutual Aid Association, https://www.aafmaa.com/learning-hub/life-insurance/tools/1035-exchange
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor. Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.
Download The Guidebook To IPWM
Learn More About How Investment Property Wealth Management works.