As life progresses, your needs evolve. The current situation may not be in line with your objectives 20 years from now. This could pose a problem for long-term commitments, such as life insurance.
This is where a 1035 exchange is a good idea. Instead of surrendering your previous life insurance policy, and starting from scratch with a fresh one, a 1035 exchange permits you to transfer the value of your policy to a new one that is compatible with life changes. We’ll look into this possibility in greater depth.
What is a 1035 Exchange?
A 1035 exchange permits you to transfer existing life insurance, annuities or long-term insurance policies to an entirely new policy without having to pay income tax.
For instance, if you own a term life insurance plan that is no longer serving your needs, such as if you’ve cleared your mortgage or your children have grown up, you can swap it for a new one that has updated benefits or with lower rates, without penalty or tax.
Rules and requirements for the exchange 1035
- Policies that can be eligible for an exchange of 1035 include annuities, life insurance, as well as long-term health insurance.
- The exchange should involve qualified contracts and must be in- kind.
- The initial policyholder has to remain the same when the process of exchange begins.
- You cannot take the contract cash or cash out any money off it at the time of exchange.
- The exchange has to be made straight from one institution to the other to avoid paying income tax.
5 Benefits of a 1035 Exchange
A 1035 exchange can provide a variety of advantages, such as the ability to change the coverage without the need to trigger capital gains tax, lower the cost of insurance, and enhance the policy’s terms.
1. You can upgrade your insurance
A 1035 exchange permits you to swap your existing life insurance policy to an alternative with greater benefits. If your family or life situation has changed, you are able to find a policy that is suitable for your needs, without having to pay the amount you’ve already paid.
2. Change to a lower-cost policy, but without having to pay taxes
You can exchange your costly life insurance policy in exchange for a lower policy, and you won’t have to be taxed on the amount you’ve earned from the policy. Simply transfer the value of the previous plan to the new to avoid the tax-paying event.
3. Delay taxes for your earnings
If you have a 1035 exchange you aren’t taxed on the cash the policy earned until you cash it out. Instead, the profits continue to grow tax deferred through the new policy or annuity. The value of your money is able to grow over time without the immediate tax burden which means you can save more savings for growth in the future.
4. Keeps the original value of your policy
The exchange does not cause you to lose the value you’ve created in your previous policy. The cash that’s grown or accrued in your previous policy isn’t required for tax payment. The tax is due when you cash out your account and avoid becoming liable.
5. Get better products and services.
Insurance products are always evolving, and transferring policies lets the user upgrade to better insurance policies with lower costs, greater coverage, or even more benefits without the additional tax burden. It’s an excellent way to keep current with the latest choices for insurance.
5 Potential Pitfalls and Considerations Before Executing a 1035 Exchange
Although tax benefits may be attractive, a variety of factors could affect a 1035 exchange’s total value and the ability to meet the requirements.
1. The higher cost of living could derail savings
Although your premiums are lower, the new policy could include higher fees or costs. These costs could cancel out the savings that you were hoping for.
2. Charges for surrender can decrease the value
If you transfer the old insurance policy you may be required to pay surrender fees, which are charges to cancel the old policy before it expires. They can, however, limit the amount you can transfer to your new policy.
3. IRS issues can cause tax complications
If you make a mistake when doing the exchange, for example, reporting the transfer incorrectly or not adhering to the IRS regulations, the IRS might consider it an event that is tax-deductible. If that occurs, you could be hit with a surprise tax bill for the profits from your previous policy.
4. You could lose important policy features
If you switch to a new policy, there’s a possibility that you’ll lose benefits that were important to the old policy, such as guaranteed death benefits or other riders. These benefits may not be offered with the policy you’ve chosen, which could reduce the value of your policy.
5. Long-term commitments can pose risk
A new policy may be accompanied by the possibility of a “contestability period,” usually two years. If during this time you submit a claim the insurance company could scrutinize it further and could refuse or delay payment in the event that there were mistakes or omissions in the application process.
Strategies for Using a 1035 Exchange Effectively
You can benefit the most from a 1035 swap by planning your strategy and making sure that it is aligned with your financial objectives. Here are some helpful tips to use this insurance plan prudently:
- Slitting benefits through partial 1035 exchanges
It is possible to divide one policy into several ones, allowing you to have greater flexibility. For example, you can keep a portion of your life insurance and transfer a portion of its worth to an annuity as retirement income. This method ensures that your financial requirements in different areas are taken care of while still conserving the tax benefits.
- Converting life insurance into long-term insurance for care
As you get older the priorities you set may shift to covering the potential cost such as health care. Through the exchange of policies you can upgrade your policy to include long-term care insurance which allows you to receive the financial support you need and death benefits at the same time.
- Preserving cost basis for tax benefits
Transferring the cost basis of your previous policy to a new policy helps you save tax on any income. This puts more money into your pockets, particularly in the event that you’re required to liquidate your insurance fund.
- Accessing better investment options
If the current plan is no longer sufficient for your needs, a 1035 exchange allows you to change to a policy that has better features, such as less charges as well as more investing options without having to pay taxes.
Be Confident to Move Forward
The exchange of 1035 offers the chance to enhance your financial plan, however the most important thing is taking actions. Working with trusted advisors and aligning your policy with your long-term goals will make for an easy transition.
Your financial life is constantly changing, so make sure that your financial policies change in line with the changing times. If you partner with the right professionals, you can leverage the full potential of a 1035 exchange and enjoy long-term financial achievement.
