1035 exchanges are flexible insurance planning tools! Did you know that you can 1035 exchange one (1) life insurance policy into two (2) separate policies?
Section 1035 of the Internal Revenue Code (IRC) allows a client to exchange one life insurance policy for another life insurance policy so long as the exchange is deemed a “like kind exchange”. Section 1035 also addresses annuity and endowment contracts, but they are not the subject of this ONEIdea.
In order to be a valid and compliant 1035 exchange there are several requirements:
1. The exchanged policies must have the same owner and relate to the same insured;
2. A single life policy cannot be exchanged into a second-to-die policy and;
3. A second-to-die policy cannot be exchanged into a single life policy, unless one of the two insureds on the second-to-die policy has passed away.
Section 1035 is a complex section of the lRC. These exchanges must be handled carefully in order to avoid adverse tax consequences because they are fundamentally used to avoid any taxable gains that may exist on the contract(s) being exchanged. While there is no specific guidance from the IRS on one to two (or more) contracts being part of an exchange, there are many insurance companies that will accept them with specific processes for handling the exchange in a compliant manner. However due to the lack of specific IRS guidance, carriers may require a hold-harmless or indemnification letter from the client in the event of an audit. If there is no gain in the existing contract, new coverage can be handled entirely differently and outside of the 1035 exchange regime.
Older Cash Value Policies
Very often we find older cash value policies that have been in force for a period of time with high cash values that exceed the cost basis (amount of premiums paid) of the contract. Following are a few reasons why your client may be better served financially by obtaining another life insurance contract or combination of contracts:
1. The older policy may have a high cash value to death benefit ratio (a low net amount at risk) and the insured would like to purchase more insurance coverage;
2. The older policy may be based upon an outdated mortality table whereas a new policy may be more cost efficient; and
3. The older policy may not have a long-term care or chronic illness benefit which is now an important need for the client.
There are many reasons for an advisor and client to explore implementing a 1035 exchange. Matt is a 50-year-old male in good health. He has owned an $800,000 policy for many years and has funded it religiously; it currently has $200,000 of cash value and does not require the payment of any additional premiums at this time. In reviewing Matt’s insurance needs, his advisor identifies two gaps in Matt’s coverage:
1. Matt’s current policy does not provide enough income replacement for his family and his original objective of cash accumulation goals have been met through other investments; and
2. Matt does not have any long-term or chronic care coverage in the event of a chronic illness, which could put a strain on his retirement savings.
Solution with Carrier X’s Blended Strategy Solution
Matt applies for two policies:
1. An Index Universal Life in the amount of $800,000 effectively replacing the previous policy. He pays a $145,022 single premium via the 1035 exchange for the new contract. This premium is sufficient to guarantee the contract to age 90 and have it endow at age 121, assuming current mortality rates and an S&P index assumed rate of 5.37%. Additionally, the product offers a Chronic Illness Rider with a 90-day elimination period and a benefit up to the current HIPPA limit of $11,100 per month.
2. A 20-Year Guaranteed Term UL from one of our carrier partners with an Income Provider Option Rider which converts the death benefit into a 20-year income stream. The $54,978 single premium via the 1035 exchange makes up the balance of the $200,000 exchange. This buys a 20-year term policy in the amount of $1,427,395 which would convert to a guaranteed 20-year income stream of $87,710 per year for a total benefit payout of $1,754,204.
Should Matt pass away any time during the 20-year period, $800,000 will be paid in a lump-sum to his beneficiary(ies) from the Index Universal Life policy, PLUS $87,710 will be paid for 20 years from the 20-year term contract. After age 70, Matt would continue to have the $800,000 in protection he initially had with over $300,000 of growing cash value that he can use in the event of any cash needs during retirement. Finally, Matt’s new IUL contract includes an $11,100 per month Chronic Illness Benefit (current HIPPA limit) with a benefit pool of up to $800,000 to draw from during his lifetime.
It is very likely you have clients with old whole life, current assumption universal life or variable life contracts that possess a meaningful amount of cash value. These policies may be ripe for updating to include the host of currently available living benefits that newer life insurance contracts afford. Now is the time to reach out to your clients to conduct policy reviews of existing insurance portfolios.
Do not miss this opportunity to bring further value to your clients by ensuring that their life insurance portfolios reflect their current financial planning needs.
Please call AgencyONE’s Marketing Department at 301.803.7500 for more information or to discuss a case.