The insurance industry has seen many social and demographic changes that, in turn, have resulted in additional changes to the design and cost of life insurance products. Many longtime policyholders have recognized these developments and considered acquiring new or different policies. Periodically helping your clients assess their life insurance policies is critical to maintaining effective risk management and estate liquidity. Fortunately, there is a way to exchange an old policy for a new one without saddling your clients with a heavy tax burden.
This tool is known as a Section 1035 exchange. It allows clients to swap out their policies without having to pay taxes at the time of the exchange on any gain that builds up in their old policy. Many people refer to this exchange as tax-free, but the gain is actually deferred.
Generally, IRS rules allow clients to exchange an old life insurance policy for a new life insurance policy or annuity. You are also allowed to exchange one annuity policy for another. You cannot, however, exchange an annuity for a life insurance policy while using the tax-deferred provision. The insured or annuitant must be the same under both the old and new policies, yet there is no requirement that the owners be the same after the exchange. Finally, clients can exchange multiple policies without recognizing gain.
You should be particularly careful when making a Section 1035 exchange if your clients have outstanding loans on their policy. The IRS recognizes outstanding loans when figuring policy gain. Therefore, to avoid being taxed, your clients may have to pay off their policy loans. Such an exchange may not always be the appropriate way to take advantage of lower costs.
Clients should be prepared to provide new evidence of their insurability in most cases. If their health has deteriorated since they bought the old policy or they are no longer insurable, the insurance company may deny such an exchange or raise premiums. You should evaluate your client's current insurance situation to ensure they have the best coverage.
Bill Laird can be reached at 904-858-4100 or bill.laird@raymondjames.com.
