Should You Exchange Your Life Insurance Policy?
If you own a life insurance policy, you may have been approached to exchange it for another new policy. You need to know that even though the tax laws make the exchange income tax free and the new policy may appear better to you, you may be losing—not gaining—if you make the exchange. We are issuing this Alert because, increasingly, life insurance exchanges may involve variable products. Variable products are securities, and this Alert will provide information to help you evaluate whether the exchange is right for you, and how you can find out what you need to know to make an appropriate decision.
Types of Life Insurance
There are various forms of life insurance products. Although features and benefits may vary, the following is a general description of typical characteristics of various types of life insurance policies.
Most variable life insurance policies and variable universal life insurance policies are securities registered with the Securities and Exchange Commission (SEC). Registration requires that investors receive important financial and other significant information concerning the securities being offered for sale. This enables investors to judge for themselves if the securities are a good investment. These regulations also provide important remedies to investors if they can prove that there was incomplete or inaccurate disclosure of important information provided to them.
The Internal Revenue Service allows you to exchange an insurance policy that you own for a new life insurance policy insuring the same person without paying tax on the investment gains earned on the original contract. This can be a substantial benefit. Because this is governed by Section 1035 of the Internal Revenue Code, these are called "1035 Exchanges."
But this benefit comes with some important strings.
A transaction in which a new insurance or annuity contract is to be purchased using all or a portion of the proceeds of an existing life insurance or annuity contract is referred to as a "replacement." A 1035 Exchange is a type of replacement transaction. Although the term "1035 Exchange" is often used to describe any form of replacement activity, technically not all replacements are Section 1035 Exchanges and as a consequence are not tax-free.
Reasons to Exchange an Existing Policy?
There are various reasons why a life insurance policyholder may want to replace an existing policy with a new life insurance policy. For example,
Reasons Not to Exchange an Existing Policy
There are also various reasons why replacement of an existing insurance policy may not be a good idea. For example,
What You Should Watch For
You should exchange your life insurance policy only when you determine, after knowing all of the facts that the exchange is better for you and not just better for the person who is trying to sell the policy to you.
Both variable life insurance and variable universal life insurance are securities. Those who offer these products must follow SEC, FINRA, and state securities regulations, in addition to state insurance law. This means that a broker must tell you the important facts about the pros and cons of the exchange. Your broker or insurance agent should recommend such an exchange only if it is in your best interest and only after evaluating your personal and financial situation and needs, tolerance for risk, and the financial ability to pay for the proposed insurance policy.
Your broker or insurance agent may recommend that you use insurance policy values, such as loans or withdrawals, to pay premiums for a new life insurance policy. This activity is generally called "financing" premiums. It may not be appropriate for you. For example, withdrawals from existing policies may be subject to federal income tax and may reduce the death benefit. Borrowing money from an existing policy will almost certainly reduce the death benefit. Withdrawals or loans may make it more difficult to keep the original policy in force without additional out-of-pocket premium payments. If you can't keep the original policy in force, you will lose the insurance protection and the loans themselves may give rise to tax consequences. Remember for a transaction to qualify as a 1035 exchange, the old policy must actually be exchanged for the new policy. Many states and brokerage firms require forms to reflect customer acknowledgement of a replacement transaction. These forms typically are signed by the insurance policy owner and the broker or agent. These forms may provide a comparison of the features and costs of an existing policy to a proposed policy, and point out what you need to focus on when considering an exchange. Some brokerage firms may provide brochures or educational material designed to outline the possible advantages and disadvantages of the transaction. You should review these forms and materials closely.
Regardless of whether such forms are provided, you should specifically ask the person recommending that you exchange or replace your existing policy to provide you with illustrations for your existing policy and the new policy. You should also ask:
You should not sign any exchange form or agree to exchange or purchase an insurance policy until you study all of the options carefully, have all of your questions answered, and are satisfied that the exchange is better than keeping your current policy.
If You Have Questions or Complaints
For additional information about variable life insurance policies or variable annuity contracts, go to:
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