A periodic life insurance review is essential to ensure life changes have not altered the original intent for purchasing a policy, cover new or additional requirements, address concerns about the financial soundness of the insurer, and deal with various other issues. However, replacing a life insurance policy can create adverse federal income tax consequences. Specifically, a taxable gain can result if the policy is surrendered when its cash surrender value is greater than the tax basis in the policy. The policy’s tax basis is typically the total premiums paid less any tax-free distributions, e.g., dividends or the surrender of part of the policy.
With careful planning, however, a policy exchange that qualifies under Internal Revenue Code Section 1035, known as a “1035 exchange,” can be used to replace one life insurance policy with another. Any gain or loss generated upon such an exchange is not recognized currently for income tax purposes.
As previously noted, individuals may consider replacing or exchanging life insurance policies for a number of reasons. One of the more important reasons is the financial strength and soundness of their insurance company. Individuals whose policies are held by companies with questionable stability often want to replace them with those of companies deemed more financially sound, usually based on the ratings of companies that rate insurance company financial strength. Replacement with policies from a more financially viable company may avoid a future loss of benefits or value in the event the initial insurer becomes insolvent.
Some policy holders benefit from replacing a policy with one that provides an increased rate of return. The fees charged by insurers may also be a factor since they affect the policy’s rate of return. Individuals who own multiple policies may want to combine those into fewer, larger policies to ease the administrative burden of maintaining them. Finally, an individual’s financial needs may change, making one type of contract or policy more desirable than another.
Individuals contemplating a 1035 exchange of policies should be aware of certain disadvantages of making an exchange. With respect to a life insurance policy, an exchange for another policy may start a new incontestability period (the period of time the insurer has specific rights to deny a claim). There may also be disadvantageous provisions within the new policy. Finally, additional fees and other costs may be associated with an exchange.
Note: The 1035 exchange provision applies to life insurance, annuity, and endowment contracts. Qualifying exchanges include not only policies of the same type, but also, in some cases, policies of different types.