By Stephen W. Bedikian, Associate Wealth Advisor
Key Takeaways
- A 1035 exchange can help policyholders replace an outdated or underperforming life insurance policy or annuity with a product that better fits their current financial needs.
- Several life changes may prompt a policy review, including changes in interest rates, dissatisfaction with annuity performance, or evolving long-term care needs.
- Tax treatment and eligibility are key considerations. A qualifying 1035 exchange can defer recognition of gains, but IRS rules and contract requirements apply.
- Exchanges involve trade-offs. Surrender charges, fees, contract terms, and the potential benefits of a replacement product should be evaluated before making a decision.
How Does a 1035 Exchange Work?
Many people buy a life insurance policy or an annuity to meet a specific need, but as their circumstances change or the investment environment changes, they neglect to consider whether the product still makes sense for them. This is often motivated by a concern that they could lose all the money they’ve already put into the policy or annuity if they want to get out of it.
Fortunately, via a 1035 exchange, the federal tax code provides an opportunity for a tax-free exchange of an existing life insurance policy or annuity into a better or more suitable one. (The name comes from the relevant tax code section.) As long as the owner, policyholder and annuitant (the recipient of the annuity) remain identical, a current life insurance policy can be exchanged into a new policy or an annuity. An existing annuity can be swapped for a new annuity – but not into a life insurance policy.
Life insurance policies and annuities often have a surrender period lasting 3-10 years, most commonly 5-8 years. If you surrender the product during that period, there is a surrender charge, so it’s usually best to hold off doing a 1035 exchange until after the surrender period expires.
When Should You Consider a 1035 Exchange?
Replacing an Older Annuity Such as ZIRP Era Annuities
Many fixed income annuities were purchased during the zero-interest rate policy (ZIRP) period following the Great Recession. Investors were reaching for income and the tax-deferred rates that could be obtained from buying an annuity were better than bank CD rates at the time. However, interest rates have risen dramatically over the past few years. In some cases, that old annuity that may be paying 3% interest could be exchanged into a new annuity paying significantly more – potentially more than 6% annually.
Reviewing a Registered Index-Linked Annuity (RILA)
These annuities have been very popular because they offer potential for upside yield via a link to a stock market index, while simultaneously providing a floor, which is typically zero percent. Conceptually, it’s like investing in the stock market but with no downside risk.
However, the devil is in the details. Often the link between the annuity performance and the index is governed by a fiendishly complex algorithm that can require a page or two of dense legalese definitions in the annuity contract. Purchasers often find that even when an index rises dramatically, they only get low single-digit increases in their annuity and still have to pay steep annual fees.
Reassessing an Indexed Universal Life (IUL) Policy
This type of permanent life insurance policy is a cousin to the RILA in that performance is linked to an index, is subject to a cap, and has a limited participation rate related to a designated index.
The difference is that it also has a death benefit. Sometimes the index is a common one like the S&P 500 and sometimes it’s a custom index licensed by the insurance carrier. Again, the issue is often that the purchaser doesn’t fully appreciate the tradeoffs; it can take years to realize just how poorly the product can perform even in a roaring bull market.
Addressing Long-Term Care Needs
Often a life insurance policy is purchased to provide a death benefit when there are young children in the household. But as the policyholder ages, the more immediate need may become protection against potential long-term care expenses.
Insurance carriers now offer what are referred to as ‘hybrid’ policies with accelerated benefits riders that allow the policyholder to access a portion of the death benefit to cover long-term care expenses. This could be another reason that an older policyholder may want to consider an exchange.
We’re happy to review your existing policies with you for best fit
If you have a life insurance policy or an annuity and haven’t done so already, why not review it with us? The opportunity cost of staying in a complex and poorly performing product can continue to accumulate over years. A 1035 exchange may allow you to transfer the value you’ve accumulated in your policy or annuity on a tax-free basis.
Reach out to Halbert Hargrove to see if we can help you.
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