1035 Exchange

Depending on the type of life insurance policy you have in place, surrendering a policy may create a tax liability. Executing a 1035 exchange is a strategy for potentially preserving your assets and avoiding a tax bill when surrendering a cash-value life insurance policy. 

What is a 1035 exchange?

A 1035 exchange, named after Section 1035 of the tax code, allows for a tax-free exchange of insurance products. The primary purpose is to facilitate the exchange of one insurance policy for another insurance policy without triggering an immediate tax consequence. This allows you to align your insurance more accurately with your current needs. For example, when you initially purchased your life insurance policy, your goal was probably to provide for your spouse and children in the event you passed away.  As you age and your wealth grows, your objectives have likely changed. This could allow you to exchange a cash-value life insurance policy for a long-term care policy. 

Often, individuals cash in a life insurance policy because the premiums are high, the death benefit is relatively low compared to their other assets, and they believe they can self-insure. Especially if you do not need the cash value, you should consider not paying the taxes and potentially bumping yourself into the next tax/Medicare bracket.    

Example: 

Katie is 55 years old and has a whole-life policy that she does not need or want to pay the premiums on. It has a $100,000 cash value and a basis of $60,000.  

• If she surrenders the policy, she will pay ordinary income tax on the $40,000 gain and will not receive any future insurance benefits. 

• If she executes a 1035 exchange from her whole life policy to a single premium long-term care policy, the $100,00 cash balance will be transferred to the new policy with no tax consequences. Doing the exchange allows the cash-value funds to retain their tax-deferred status. The 1035 exchange to a single premium LTC policy will eliminate her ongoing premiums and create future tax-free payments for nursing homes, assisted living, and other forms of long-term care assistance. If the benefits are unused by the end of her life, the policy will return the premium.   

Conclusion 

In conclusion, a 1035 exchange can strategically reposition your insurance policies to align more with your future financial goals. THOR does not sell insurance but can help illustrate pros and cons of strategies like this in your financial plan. 

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