What Is a 1035 Exchange? Rules, Benefits & Common Mistakes

If you’ve been looking for a financial planning strategy geared towards replacing an out-of-date insurance policy or annuity without negatively impacting the amount you pay in taxes, then this is the episode for you! So, without further ado, we’d like to introduce all our loyal listeners to the concept called the 1035 exchange. Most advisors will tell you that even though it’s one of the most overlooked strategies, it can also be one of the most advantageous. In this episode we break down everything from what a 1035 exchange is to ways that you and your team can take actionable next steps that could help provide you with a fruitful financial future. 

What we’ll cover:

✅ 1035 exchanges explained.

✅ Rules & regulations.

✅ Best practices.

✅ Common mistakes.

We at The Wealth Cafe encourage you to speak with your financial team as soon as possible, so that you can see if this is a fit for your long-term goals and isn’t going to negatively impact your current strategies.

☕️For more tips and advice, make sure to subscribe to the show so you don't miss an episode!

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Transcript

SPEAKER_00 0:15

One of the most overlooked strategies when it comes to tax planning, financial planning, and more specifically insurance planning is how you can utilize a 1035 exchange within your own finances. Why does this matter? Well, a 1035 exchange can help you get out of a policy, whether it's an annuity, a life insurance policy, an IUL, whole life, whatever it might be, that isn't the right fit for you anymore. I will have so many clients that come into my office with different statements or policies that other insurance brokers have sold them and they're sitting there scratching their heads, going, I don't really understand where this policy fits into my financial plan. I don't know what it's doing for me, I don't know what the benefit is, or it's not doing what that insurance person promised them it would do. Now, this happens more often than you would think. So if you're sitting here having the same thoughts thinking, oh my goodness, I know exactly what you're talking about. I have a policy that's locked away in my drawer that I've been ignoring for years because I don't know what to do with it. And honestly, I'm a little ashamed that I even got talked to it in the first place. Know that you are not alone. This happens time and time again. And I always have those people that are sitting there saying, How did I fall for this? Why didn't I read all of the paperwork? Well, a lot of things can be good on paper or can be sold really well. But all we can do now is move forward, and this can is how we can use a 1035 exchange. And today I'm gonna talk through the nuances of how they work, where they fit into place, and what things you need to do step by step to make sure you can use a 1035 exchange to your benefit because if you mess things up, it can cause a lot of unwanted or unnecessary taxes that nobody really wants to pay. So let's dive into 1035 exchanges. Let's start by breaking down what actually is a 1035 exchange. Now, this is not some secret thing, this is not some little nuance. Honestly, it's just a piece of the IRS tax code. It's section 1035 of the IRS tax code, hence why it has its name. What the purpose is, is that it allows you to go from one contract to another. And if you follow the right procedure and do things in the right manner, it will prevent you from realizing a gain on your policy. So you essentially are going from one policy to the next. And typically we're doing this because we want to replace an old policy. We're saying, hey, we have something that's going to provide better income, a better death benefit. It's a better fit for you and your financial picture. The reason doesn't always have to fit within something that's listed in the 1035 exchange. You can do it for whatever reason or purpose you have. But the idea behind it is that you are doing this and following these procedures and these steps in order to avoid recognizing a gain. Let's talk about the types of exchanges that are allowed. And this is one that trips people up and they sit here and they go, why do these rules exist? I couldn't tell you other than the IRS made them. So I'm just the messenger here, but I want to make sure you understand what can happen and what exchanges can occur. The simplest way to break it down is you can go from one life insurance policy to another life insurance policy. And it doesn't matter if you're going, let's say, from a whole life policy to an IUL policy, it can be one life insurance policy to another, whatever type of policy, but it has to go from life insurance to life insurance. You can go from a life insurance policy to an annuity policy, that type of exchange is allowed, or you can go from an annuity to another annuity. Once again, it doesn't matter what type of annuity it is, it just has to go from one annuity contract to another annuity contract. However, here is the big nuance of what is not allowed. You cannot go from one annuity contract to a life insurance contract. So if you have something like a variable annuity, a fixed annuity, whatever it might be, you can't then all of a sudden say, you know what, I don't want this annuity. We're gonna skip the lifetime income that we thought we were gonna be getting through this policy. It's not the right thing. We're gonna go over to a life insurance policy instead. That type of exchange under a 1035 is not allowed. The other key thing to know when you are doing a 1035 exchange are some of the rules in order to make a 1035 exchange qualify for this tax exempt treatment. Now, this isn't to say you will never pay taxes, it's just as you are going from one contract to another, you will not see the taxes occur. The first thing you need to know is you need to go from the same owner to the same owner. So let's say you, as Jane Doe, are going from a whole life policy and Jane Doe, you are then going to have an index universal life policy. That's fine, that is allowed. What you can't do is say, okay, Jane Doe and John Doe are going to then go from a whole life policy to just an index universal life policy with Jane Doe on it. You would need to have both owners on the apology on the policy. The other thing you also can't do is say, Jane Doe is just on this life insurance policy. We're now going to change it and have Jane Doe and John Doe on this policy. It needs to go from the same ownership to the same ownership. Once again, whether you are going to life insurance to life insurance, life insurance to annuity, or annuity to annuity, that part is allowed, but it needs to be the same owner no matter what you are doing. I will share one caveat that I have been seeing a lot lately, and that is a lot of the larger wirehouses that are out there, a lot of the big banks, they will be the owner on top of a policy, so they say. However, that doesn't necessarily mean that they are the owner of the policy. And if you do a 1035 exchange, that you are then having an ownership change. Those are a little more nuanced, and you want to make sure you are working with your insurance team because, in theory, you are still the owner of that policy. You never handed the funds over. So that is one of those little individual cases where I have seen things pop up where the larger broker looks like they are the owner of the policy and it's for the benefit of the client. However, the client is still technically the owner in that case. Make sure you're asking questions, make sure you understand what's going on in those situations. However, if you see that pop up, no, it does happen from time to time, but something you do want to be mindful of if you are doing a 1035 exchange. The other thing you want to be mindful of is are the funds transferring directly? An example of this is let's say you have that whole life insurance policy, you have the money that's coming from the policy, you never want the check to come to you as the beneficiary or as the client. The funds need to go from that exact policy to the next policy. You should never take possession of them. They shouldn't come to you and you start issuing checks. It is needs to go from one company to the next company and shouldn't be coming into your hands. The last thing you want to be mindful of is are there any loans on your current policy? If you have outstanding loans on your policy and you are looking to do an exchange, that can have implications on the tax side. If you do have any outstanding loans, make sure you are communicating that to either your current insurance broker or the new insurance broker. Make sure those are clearly communicated. So that way you can either create a plan on how you're going to tackle them and pay them back, or understand what tax implications you could occur by having outstanding loans on any of those policies and what that will look like. Every policy is going to be built a little differently, which is why I'm not diving into it too much and all of the nuances, but this is something you need to be aware of, communicate, and understand what are the implications of this if I'm to exchange from one policy to the next, because this could have tax implications to it. When you're doing a 1035 exchange, there are some key mistakes to watch out for. The first of which is not understanding surrender charges. Now, surrender charges a lot of times can be hidden in some policy documents or not always communicated. But what happens is you may see the face amount of what your life insurance policy or your annuity is worth. But that doesn't always mean that after surrender charges, that's the actual amount that would transfer over. Let's say, for example, you have a policy that is worth $550,000 as a current policy value, but after surrender charges is really $525,000. That means that if you are then to do a 1035 exchange from one policy to a next, it's not that $550,000 that's going to transfer into the new policy. It's that $525,000 that would go into the new policy. Depending on how old your policy is, the surrender charges could be higher or lower. For your newer policies, you're going to see a lot higher of surrender charges because the insurance company or the annuity company, whatever it might be, is trying to disincentivize you from going into a new product, right? They want to keep you there for as long as possible so they can recoup their money. And they want to make sure that you are really riding out the contract for as long as possible and really that disincentivization to go to a different contract, even if it's within their same company and you're just going from one product to another. It's something to be aware of and it may be a right fit and to do the comparison of, okay, if we go to another product, here's how long it would take me to recoup those surrender charges. And it makes more sense because we're looking at the longer-term play and strategy, and you would rather get out of that policy to have things grow for the future. But these are key things to look at when you are doing a 1035 exchange. From a tax perspective, they won't impact things as long as you are following all the right rules in the way you're transferring. But when you're going from one policy to another, it is something to be mindful of because there is a loss of value that you are incurring. The other thing to keep an eye out for is what features are you trading off by doing an exchange, especially if you're going from something like a life insurance policy into annuity, which is allowed under a 1035 exchange. Make sure you understand what that means for your lifetime and also the next lifetimes of the legacy you are leaving. You may have taken out a life insurance policy saying, hey, I want to leave this for the generations behind me. And now if you're switching to something like an annuity to take that income during your life, that's a different strategy. And you need to keep that in mind in terms of taxes that you're going to see on the income of that, depending on what type of money it is. You need to plan for, okay, now how does that change things in terms of the legacy for the future? It's also going to change a lot of the different benefits that you have. Let's say you had some type of disability rider or critical care writer that was on your life insurance policy. You may not have that on your annuity. Things are always going to be different, and so it may not be a like-for-like comparison. It's typically not if you're doing an exchange. Newer isn't always better. However, you may be sitting here saying, you know what, my life has really changed and evolved. Some of the riders or things that I set up in this one policy, they don't really impact my life anymore. I don't have to, for example, worry about young kids or a spouse or aging parents. I want to focus on me and my life. And that's why I'm going to exchange in a different product. Make sure you understand the reasoning behind why you are exchanging into a different product and all the different riders and pieces that are going into it and what you are paying for. If you are adding riders onto a policy, do you want them? Do you need them? What do all those pieces look like? And how do they actually add to your financial picture going forward rather than just add in unnecessary costs? The third thing that a lot of people forget about is you are now resetting that surrender clock. So I previously had talked about the surrender charges that you are seeing and that the newer policies, they typically have higher surrender charges to stop you and disincentivize you from going into another policy. When you go into a new policy, that clock restarts and you are resetting that period of time, which a lot of people sit here and say, I'm willing to take that risk, but it's something to be mindful of. Are you willing and ready to lock in that clock and restart that period of time? And these are conversations to be having with your financial team to say, what are the pros and cons of this situation? But always something to be mindful of. The last thing is the tax portion. You want to make sure you are following things to a T, that you don't have outstanding loans that could potentially trigger taxes, that you aren't mishandling the funds and having them come to you rather than directly going to the other insurance company, or that you aren't taking out partial withdrawals or pieces on the way that mess things up and could cause the 1035 exchange to not occur. It's a very step-by-step process and make sure you are working with the team to say, hey, how do I make sure this seamlessly happens so that there are no gains that come into my life and we can fully execute a successful 1035 exchange? Now there are many cases where a 1035 exchange makes sense. I've seen a lot of policies that have been missold to clients, misrepresented, sold to them during times of low interest rates when they felt like they had to lock things in and didn't really understand what that meant for the longer-term future. It's always worth it to take a second look and review these policies, especially every year as your life changes. And if you sit back and say, you know what, this still works for me in my life, I'm gonna keep moving forward, that's great because then you have that peace of mind. And it's something you should be doing, checking out the beneficiaries, understanding your policy, seeing how it fits into your life. If you get a second review, then that way you also know. Understanding 1035 exchanges could have a lot of different nuances and pieces. So make sure you are working with the right financial team, understanding how it fits into your life and making sure you're following things step by step to execute this seamlessly. And that way you can have these things working in your life rather than causing a piece of confusion and uncertainty. Thanks for tuning in to this episode of The Wealth Cafe, and I'll see you again on our next episode.