Should my client exchange one life insurance policy for another? This is an excellent question which I receive from advisors around the country. Unfortunately, the answer can be “yes, no, or maybe.” depending on your circumstances. A number of complex rules govern this transaction, and as we know from all other areas of wealth management, there are always exceptions to the rules. Read the fine print or better yet, find a subject matter expert to help you explore the options.
Because everyone in the industry is familiar with FINRA, I will quote their definition of a 1035 exchange as a refresher.
“The Internal Revenue Service allows you to exchange an insurance policy that you own for a new life insurance policy insuring the same person without paying tax on the investment gains earned on the original contract… this is governed by Section 1035 of the Internal Revenue Code…”
Confusing a 1035 exchange with the purchase of a new policy is a common misunderstanding among advisors and their clients. Hence, you must clearly explain to your client that he or she must exchange their old policy for a new policy through their original life insurance carrier or from their original carrier to a new life insurance company. Clients need to understand that a 1035 exchange is exactly that: the exchange of one policy for another. It is not just the purchase of a new policy.
Hence, you need to ensure your client understands he can not, or should not, receive a check from his insurance company and use the proceeds to purchase a new policy. Should your client do this, they may incur a tax liability. A 1035 exchange is a complicated transaction and should only be considered for one or more of the following reasons:
- current policy no longer matches the owner’s current goals
- old policy has egregious fees and charges
- old policy type (whole, universal, variable, indexed universal) no longer matches the client’s current goals or best interests
- old policy doesn’t have the riders available to meet the clients current needs and goals
What are riders attached to the policy? The most common include:
- Long-Term Care Rider
- Waiver or premium if the insured is disabled
- Disability income rider
- Critical Illness rider: allows a client to accelerate a portion of the death benefit if diagnosed with an illness such as kidney failure, heart attacks, strokes, or cancer but the condition is not necessarily terminal
- Accelerated Death Benefit rider: allows a portion of the death benefit to be accelerated in the event of a terminal illness diagnosis and has become a standard rider on most insurance policies sold in the last thirty years. *Please remember, this isn’t part of the Critical Illness rider; the ADB rider is a completely separate rider
The pitfalls in a 1035 exchange are numerous, but the most critical is your client must re-qualify medically for the new life insurance policy. If their health has declined from the date of the original purchase of the policy, then other insurance companies including the client's original carrier may rate or even decline the exchange. Further, even if your client is in good health, the insurer may decide he doesn’t qualify because of age.
Keep in mind there can also be surrender charges. Further, even if your client is in good health, the insurer may decide they do not qualify because of age. Remember, based on the needs of your client it may not make sense or be in his or her best interest to make an exchange.
Surrendering a life insurance policy can be complicated. However, for the right reasons, it can be a tremendous advantage for your client. By understanding your client’s goals and exploring all the options available you will further cement your role as the trusted adviser serving the whole client.
To learn more about this topic, register for our Capitalizing on the Insurance Opportunity course.
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Contributing Writer: Subject Matter Expert Charles McCain