If you own a life insurance policy, you might be 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 might appear better to you, you might lose—not gain—if you make the exchange. Be sure to evaluate whether the exchange is right for you before making a decision.
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." 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, not all are tax-free.
Reasons to Exchange an Existing Policy
There are various reasons why a life insurance policyholder might want to replace an existing policy with a new policy. For example:
- Your reasons for purchasing life insurance might have changed over time.
- Improved health or mortality improvements across the general population might result in insurance coverage at a lower cost.
- You might have concerns with the solvency of the insurance company that issued the original policy or with the service of the investment professional or insurance agent who sold you the policy.
- A new life insurance policy might have more desirable features or benefits.
Reasons Not to Exchange an Existing Policy
There are also various reasons why replacement of an existing life insurance policy might not be a good idea. For example:
- You might reduce the cash value built up in your original policy if a portion of the accumulated amount is applied to the new policy's first-year expenses, including commissions.
- Life insurance policies (other than term policies) often include early surrender charges, which can reduce the amount of cash value available toward the new policy. The new policy will likely have its own new surrender charge schedule, which may extend beyond that of the original policy.
- You might pay higher premiums if, for example, your health has declined since the purchase of the current policy.
- The new policy typically will have a new contestability period—a two-year period from the issuance of the new policy during which the insurance company could challenge a death claim based upon a misstatement on the application.
- There may be unfavorable tax consequences caused by surrendering an existing policy, such as a potential tax on outstanding policy loans.
What You Should Watch For
Only exchange your life insurance policy if you determine, after knowing all of the facts, that the exchange is better for you and not just better for the person trying to sell you the policy.
Both variable life insurance and variable universal life insurance are securities. Those who offer these products must follow Securities and Exchange Commission (SEC), FINRA and state securities regulations, in addition to state insurance law. An investment professional or insurance agent must tell you the important facts about the pros and cons of the exchange. They should recommend such an exchange only if it’s in your best interest and only after evaluating your personal and financial situation and needs, risk tolerance, and financial ability to pay for the proposed insurance policy.
Using insurance policy values, such as loans or withdrawals, to pay premiums for a new life insurance policy is generally called "financing" premiums. This might 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 might 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’ll lose the insurance protection, and the loans themselves might 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 investment professional or insurance agent. These forms might provide a comparison of the features and costs of an existing policy to a proposed policy and might point out what you need to focus on when considering an exchange. Some brokerage firms might 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, 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:
- What is the total cost to me of this exchange?
- What are the new features being offered? Why do I need those features?
- Are these features worth the cost?
- Can the existing policy be modified or supplemented to provide some or all of these same features?
- What features will I lose?
- Will you be paid a commission for the exchange, and if so, how much is it?
Before signing any exchange form or agreeing to exchange or purchase an insurance policy, study all of the options carefully, have all of your questions answered, and be sure you’re satisfied that the exchange is better than keeping your current policy.
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