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.
- The tax code says that the old insurance policy must be exchanged for a new policy—you cannot receive a check and apply the proceeds to the purchase of a new insurance policy.
- The tax code also says that you can make a tax-free exchange from: 1) a life insurance policy to another life insurance policy or 2) a life insurance policy to an annuity. You cannot, however, exchange an annuity contract for a life insurance policy.
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.
There are a number of factors you should consider when deciding whether to exchange your insurance policy, including potential loss of death benefits. For more information and a list of questions to ask, see FINRA's Investor Alert entitled Should You Exchange Your Life Insurance Policy?