A 1035 Exchange Offers a ‘tax free’ Way to
Change Life Insurance Policies or Switch to
an Annuity
by Shane Flait
©2012
When
preparing for retirement, you need to
re-evaluate your insurance needs. Perhaps,
you may have a cash value life insurance
policy that doesn’t offer what you need now.
You may decide to cash it in or sell it so
you can buy another insurance product. But
you’d have to pay taxes on any gain you make
on your policy. But with a 1035 exchange,
you can bypass any immediate taxes while
converting your policy to something better
suited to you.
You
may now find coverage with lower premiums
and/or a larger death benefit if it’s been a
while since you purchased your life
insurance policy. People living longer or
underwriting guidelines that acknowledge
medical advances and other factors can
account for this. Or, maybe you no longer
need life insurance protection, but would be
better served by an income-generating
product like an annuity.
If
you sell or surrender a life insurance
policy, it may trigger taxes since
investment earnings in insurance policies
grow tax-deferred. If so, you’ll have to pay
tax on any gains you receive above what
you’ve contributed. This reduces their
effective value to you.
You
can get around this taxation by doing a
Section 1035 (IRS) exchange. It allows for
the direct, tax-free transfer of accumulated
funds in a life insurance policy (or annuity
policy) to a different life insurance
contract or even to an annuity contract.
Under a 1035 exchange, you convert ‘tax
free’ either to a more appropriate life
insurance policy or turn its cash value into
an income generating annuity to bolster your
retirement income.
Cost basis and gains
The
cost basis of your life insurance policy is
the total gross premiums you paid less any
dividends or partial surrenders (loans)
you’ve received. You can have the cash value
of this policy transferred directly into
your new insurance policy or contract by the
insurance company so you never have
possession of the money. Note too, that if
the cash surrender value of the old policy
is high and you do the tax free exchange the
preserves and transfers your tax basis in
your old policy into the new one, you’ll
minimize eventual taxation of the new policy
if and when you decide to surrender it down
the road.
As a
hypothetical example, assume you’ve paid
$1,000 per year for 20 years for your old
policy and received $4,000 in dividends.
Your cost basis in the policy is $16,000 (20
years multiplied by $1,000, less $4,000)
compared to the policy's cash surrender
value of $10,000. If you surrender the old
policy and purchase a new one with the
$10,000 surrender value, the cost basis of
your new policy would be the $10,000.
But
if you "exchange" the old policy for the new
under a tax free 1035 exchange, you can
retain the $17,000 cost basis of the old
policy. Preserving your cost basis will
shelter a lot of future gains you may earn.
You
can exchange several policies for one new
one too. But, realize that all the policies
must have the same insured party and owner.
Also, recognize that the purchase and
exchange of life insurance involves costs,
fees, expenses and potential surrender
charges and depends on the health of the
applicant. Not all applicants are
insurable. If a policy is structured as a
modified endowment contract, withdrawals
will be subject to tax as ordinary income
and withdrawals prior to age 59 ½ are
subject to a 10% penalty.
END
Shane Flait is a writer and educator. Get
more info at
www.EasyRetirementKnowHow.com
