In its most basic form, a 1035 exchange is a tax-advantaged way policyholders can change their life insurance, annuity, and long-term care coverage.

To most, it’s just a dull section in the tax code. To insurance agents and financial advisors, it’s an incredibly valuable sales tool for updating coverage, leveraging funds, and delighting clients.

Let’s take a look at the ins, outs, and in-betweens of this brilliant tax instrument.

What Is a 1035 Exchange?

Generally speaking, a 1035 exchange relates to section 1035 in the Internal Revenue Code from the Internal Revenue Service. It allows life insurance, annuity, and long-term care insurance (LTCi) policyholders to trade in their current policy for a new one without any tax penalties. Those with endowments can use 1035 exchanges as well. There are some restrictions, though. Below are the acceptable 1035 exchanges.

Allowable 1035 Exchanges

THIS PRODUCT TO… Life Insurance Non-Qualified Annuity Qualified LTCi Endowment
Life Insurance YES YES YES YES
Non-Qualified Annuity X YES YES X
Qualified LTCi X X YES X
Endowment X YES YES YES

The Pension Protection Act (PPA), which became law in 2010, expanded 1035 exchanges to allow individuals to use a non-qualified annuity, life insurance, or a qualified LTCi policy to get a new qualified LTCi product. Before the PPA was passed, individuals could only exchange a non-qualified annuity to a different annuity and a life insurance policy to an annuity or a different life insurance policy.

Why Should You Care About 1035 Exchanges?

As you know, the financial and coverage needs of a client change with time. We recently wrote about how there are different life insurance needs at different life stages. You could meet with a new client who purchased a life insurance policy from another agent years ago. After talking with the client and reviewing their policy and current situation, you may find that they’re ready to switch to a new policy or want to leverage their old assets to help plan for extended care they may need in the future. Think of a 1035 exchange as a powerful free sales tool that helps you grant your client’s wishes and earn more commission.

Through a 1035 exchange, you can take old policies clients may no longer want or need and transfer the value (and any gains!) tax free to newer ones with more features, lower costs, and/or more suitable coverage.

Through a 1035 exchange, you can take old policies clients may no longer want or need and transfer the value (and any gains!) tax free to newer ones with more features, lower costs, and/or more suitable coverage. And guess what? Writing a client into a new policy using a 1035 exchange earns you money just like any other sale would!

Writing a client into a new policy using a 1035 exchange earns you money just like any other sale would!

When Do 1035 Exchanges Make Sense for Clients?

A 1035 exchange can serve as a great way to help clients move their assets from one type of annuity or life insurance product to another. For example, a client with a variable annuity may want the security of a fixed annuity now that they’re older. Or, a client who previously purchased a life insurance product with a large death benefit may want a cheaper policy with a smaller death benefit now that their kids are all grown and financially stable. As long as they don’t have high surrender charges or outstanding loans, a 1035 exchange may be the best way to get these clients into new policies. 1035 exchanges can also play an extremely valuable role in getting LTCi prospects set up with benefits.

Why Use a 1035 Exchange for Long-Term Care Protection?

  • Long-term care is a huge financial risk, and it’s generally left unprotected.
  • 1035 exchanges allow individuals to reposition their current assets into a Life/LTCi or annuity/LTCi combination product or a traditional LTCi product.
    • With hybrid products, LTCi coverage isn’t “use-it-or-lose-it.”
    • One LTCi policy may be able to cover two lives.
  • The policyholder can potentially use the funds in their new policy to pay for long-term care costs tax free!

How Do 1035 Exchanges Work?

To get a new policy via a 1035 exchange, policyholders essentially surrender their old policy and transfer its value into the new one. The insurance companies involved must complete these actions. It’s important to note that companies are legally required to allow individuals to transfer their policy to another company; however, they’re not legally required to accept 1035 exchanges from other companies.

Here are some general 1035 exchange rules:

  • The owner, insured, and/or annuitant must be the same on the new policy.
  • Policyholders can trade in multiple contracts for a new one but not the other way around.
  • Surrender charges may apply if the old policy is still in its surrender period.
  • A transfer most likely will NOT be considered a 1035 exchange if:
    • Policyholders surrender their old policy for a check and use that check to buy a new policy.
    • Outstanding loans exist on the original policy.

Sometimes, instead of doing a complete 1035 exchange, a partial 1035 exchange may be in order. Partial 1035 exchanges are allowed, and sometimes necessary, in certain circumstances. For more information about these transactions, we recommend talking to the insurance companies participating in the deal.

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A 1035 exchange is so much more than just a humdrum provision in the tax code! It’s one of the best possible ways for life insurance, annuity, and LTCi agents and advisors to help clients update their policies. Are you taking advantage of them?

Members of the Agent Survival Guide team are not tax experts or professionals. Anyone looking to use a 1035 exchange should consult with a financial advisor, accountant, and/or tax professional.