Often a policy review of your client’s existing life insurance and annuity contracts will conclude that a more cost efficient contract with better guarantees and rates of return makes sense. This will cause a producer to seek a potential transfer of the existing cash values to a new contract via a tax free Section 1035 exchange.
IRC Section 1035 tax-free exchanges of life insurance and annuity contracts must be carefully handled to insure a smooth transfer of funds from the old carrier to the new carrier. Of course, new medical underwriting must take place for a life insurance exchange. The health of the insured may have changed between the time the original policy was issued and the potential Section 1035 exchange. Here are 5 important guidelines to keep in mind.
1. Possible Exchanges Where the Contract Owner is the Same Before and After the Exchange
- Life insurance can be exchanged for life insurance
- Life insurance can be exchanged for an annuity. This includes exchanges to either a deferred annuity or a single premium immediate annuity (SPIA)
- A deferred annuity can be exchanged for another annuity. This includes exchanges to either another deferred annuity or a SPIA
- An annuity CANNOT be exchanged for life insurance.
2. Types of Contracts that Can Be Exchanged with the Same Insured or Annuitant
- Single life to single life
- Single life to single annuitant
- Survivorship life to survivorship life
- Survivorship life (one insured deceased) to single life
- Single annuitant to single annuitantThe following exchanges DO NOT relate to the same insured(s), so will NOT achieve a tax-free transfer:
- Single annuitant to joint annuitant
- Single annuitant to single annuitant
3. Exchange of Life Insurance Policies with Loans
You must be careful when exchanging policies with loans that are in a gain position. A policy is in a gain position if the total cash value is greater than the adjusted cost basis.
- If the loan is extinguished (discharged) on the exchange, the lesser of the loan or the gain in the policy will be taxable income to the policy owner. This will generate a Form 1099-R from the carrier.
- If the loan is carried over on the exchange to the new carrier, the exchange will be accomplished tax free. However, the new policy will be issued with an outstanding loan right from the start. Many carriers have loan to value limits that must be met before they will accept a Section 1035 carry over loan.
4. Multiple Contract Exchanges
Multiple policies with the same owner and the same insured can be exchanged for a new policy. And one policy can be exchanged for multiple new policies. The cost basis of the contracts will be carried over to the new carrier and adjusted cumulatively (i.e. 2 for 1; 3 for 1) or proportionally (i.e. 1 for 2; 1 for 3) as the case may be.
5. Important Administrative Issues
Finally, be careful with the paperwork to complete a Section 1035 exchange. Carriers want the ownership to match exactly between the Section 1035 exchange form of the new carrier and the actual owner(s) of record with the old carrier. Otherwise, the old carrier may not process the exchange until the “title” ownership matches exactly. This is especially important when existing policies owned by an Irrevocable Life Insurance Trust (ILIT) are being exchanged.
Also, if a different policy owner is desired for the new policy, a change of ownership form must be executed. This change of ownership could take place either before or after the exchange depending on the specific facts of each case.
Contact your BSMG Life or Annuity Advisor when considering a Section 1035 exchange from one carrier to another carrier. Your BSMG Advisor will work with BSMG Case Managers and BSMG Advanced Sales to assure that the transfer of funds is handled in an expedited manner.
Russell E. Towers JD, CLU, ChFC
Vice President – Business & Estate Planning
Brokers’ Service Marketing Group