1035 Exchanges: What You Should Know Before You Switch

Investors, beware: 1035 exchanges are not always what they appear and often are costly and nonsensical.

Financial advisers may push a life insurance policy holder to exchange their policy for risky securities that supposedly offer greater benefit. Only after the documents are signed does the policy holder discover that they have taken on a losing strategy.

1035 exchanges make it possible to exchange one life insurance policy for another without incurring income tax. But investors should be wary about what type of new policy their broker recommends — even without income tax, these types of transactions can come with surrender fees and other financial disadvantages.

Securities like variable annuities and Variable Universal Life insurance policies (VULs) are some of the riskier securities brokers might recommend for a 1035 exchange. Make sure you know the true value of the exchange. Consider that your financial adviser might recommend a risky investment for the sake of a commission.

Why Would a Policy Holder Opt for a 1035 Exchange?

Life insurance is designed to replace income following the policy holder’s death — that way a spouse or a dependent can rely on regular policy payouts. An investor might feel that they don’t need a standard life insurance policy after their spouse dies and they have no other dependents who rely on their income. They might also find that their health was better than they originally thought, allowing them to worry less about replacing their income.

Is Your Exchange of Policies Truly a 1035 Exchange?

1035 exchanges allow a policy holder to transfer any gains from their original life insurance policy to their new policy, provided there are not outstanding loans on the original policy. Important note: Funds generated by the original policy must transfer to the new policy for a true 1035 exchange. If a policy holder borrows money from their insurance policy to purchase a new policy, the tax benefits of a 1035 exchange will not apply. In this case, the policy holder may also have to pay more premiums to keep the original policy active.

What Types of 1035 Exchanges Have the Highest Risk?

Not all 1035 exchanges are created equal. Securities attorneys may need to become involved if an investment adviser recommends that their client exchange a straightforward life insurance policy for an investment so complex that it may not be worth the hype. Variable annuities and VULs are two risky securities commonly seen in ill-advised exchanges.

Variable annuities allow the policy holders to invest the cash value of their policy in portfolios of securities. These securities could be high risk, and investors should evaluate the likelihood that their investments will generate a return. Variable annuities have risks that advisers ought to disclose, but sometimes skim over for the sake of earning a high commission. (Related: Variable Annuities: Why These Investments Often Lead to Losses.) You can trade a life insurance policy for an annuity, but this trade only goes one way — you cannot exchange a variable annuity for a life insurance policy. Also, if an investor decides they no longer want their variable annuity, surrender fees may apply to that transaction as well.

Similarly, VULs present substantial risk. Like variable annuities, their success depends on their underlying securities. Many VULs also require that the policy holder pays monthly premiums to ensure continuous coverage. There are plenty of instances of investors alleging that their financial adviser did not make these premiums clear.

Questions for Investors Considering Exchanging Their Policy:

The IRS has provided a handy explainer that covers what points policy holders should consider before exchanging their life insurance policies.

Here are a few of the essential questions to ask before surrendering a life insurance policy:

· Has your health suffered a recent decline?

· Does your current life insurance policy come with an early surrender fee?

· Do you know all the tax consequences associated with surrendering your life insurance policy?

What Steps Should Investors Take?

If you have concerns about a 1035 exchange that your financial adviser recommended, you should contact a securities attorney. Get in touch with the experienced attorneys at Fitapelli Kurta for a free case evaluation. Call (877) 238–4175 or email info@fkesq.com.