Life’s changing circumstances sometimes make it prudent to modify one’s life insurance program. Sometimes, but not always (see Should I Replace My Life Insurance Policy? and Should I Replace My Life Insurance Policy? Part 2), that modification will entail replacing an existing policy. When replacement is warranted, it can be advantageous to utilize the provisions of Internal Revenue Code (IRC) §1035.
A 1035 exchange refers to that section of the IRC that allows for the exchange of certain policies without the immediate recognition of gain. Although life insurance proceeds paid by reason of death are generally tax free, under normal circumstances, any gain on a surrendered policy is subject to federal income tax at ordinary rates on a first in first out (FIFO) basis.
Example: Joe has owned a life insurance policy for the past 15 years with a $5,000 annual premium and a cash value of $95,000. If he were to surrender the policy, he would have a taxable gain of $20,000 ($95,000 proceeds less his basis of $75,000 basis, which is the $5,000 premium paid for 15 years). That gain would be taxed as ordinary income as it is not eligible for capital gain treatment, even though it was held for more than one year.
He could avoid paying tax on that gain if, instead of surrendering the policy, he effectuated an exchange pursuant to the rules of IRC §1035. That would entail completing the requisite paperwork authorizing his current insurance company to send the 95,000 directly to his new insurance company. His initial basis in the new policy would be $75,000, his basis in the old policy, even though there would be $95,000 in the new policy. No tax would be currently due on the $20,000 gain.
Potential gains are not the only situation in which a §1035 should be considered. Let’s say had kept the policy for only 5 years and the cash value was $20,000. If he surrendered the policy, he would have a $5,000 non-deductible loss. Utilizing the provisions of §1035, he still wouldn’t be able to deduct the loss, but his basis in the new policy would be $25,000, the same as his basis in the old policy, even though there would only be $20,000 in cash in the new policy.
This rule is especially helpful if no new insurance policy is contemplated and the cash value is to be invested. §1035 allows a life policy to be exchanged for an annuity (but not vice versa). Using the example above, if the $20,000 cash value was used to purchase an annuity via a §1035 exchange and surrendered years later for $40,000, the gain would be $15,000 ($40,000 proceeds less basis of $25,000) instead of the $20,000 gain that would result if the transaction was completed without utilizing the provisions of §1035.
With the potential benefits so significant, it would be wise to consider §1035 exchange anytime a policy is to be surrendered.