Exchanging a Cash Value Life Insurance Policy Under Code Section 1035

Situation: Many modern life insurance polices contain nonguaranteed features that must be managed and reviewed. Unfortunately, while consumers are aware of the need to manage and review their investment portfolios, financial advisors may find that clients have not reviewed their life insurance policies. When a policy evaluation is finally performed financial advisors may find a client’s family, business, financial status and objectives changed, and the insurance purchased to meet those objectives may need to be changed. There are many new types of insurance products available today that were not available a few years ago. In some cases, a new type of policy can solve a client’s need for insurance in a more cost-effective manner. There may be a concern that the present policy may lapse in the future. Where one or more of these factors exist, clients should be made aware of the opportunity and given a chance to exchange the old policy for a new policy under Section 1035 of the Internal Revenue Code.

The replacement of one policy for another must be considered carefully. In addition to the tax factors, which are the primary focus of this Counselor’s Corner, there are several non-tax factors that should be considered before suggesting an exchange. These non-tax factors include: (1) new acquisition costs, (2) possible surrender penalties, and (3) the insurability of the client. Additionally, clients should be made aware that there are important protections in an old policy (e.g., incontestable clause and suicide clause) that are not immediately present in a new policy. In other words, financial professionals should suggest or recommend the exchange of an existing life insurance policy only when it is in the best interest of the client.

Solution: Assuming you are working on a situation where a Section 1035 exchange makes sense, there are several steps that must occur for the transaction to qualify for Section 1035 tax treatment. Before we go into the specific requirements and some of the nuances let’s first review why someone might want to qualify a transaction under Section 1035.

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