1035 Exchanges – Amazing and Fruitful Opportunities to Help Clients

Written by Claude Thau

February 23, 2020

Nearly every financial advisor has some substantial §1035 exchange opportunities that can help clients tremendously, compensate the advisor well and generate referrals.  Delighted clients will tell their friends about the service you provided, even if you don’t ask them to (but especially if you do ask them).

Do you have clients who have life insurance policies and deferred annuities with large gains in them?  If you don’t know, you might like to find out!

Do you have clients who would like to keep such life insurance, but stop paying premiums?

Do they realize that their gains in their annuities will eventually be taxed heavily UNLESS they §1035 them and eventually use the money to pay for LTC?  There’s about $1 trillion of non-qualified deferred annuity asset in the USA and about $2 trillion of qualified deferred annuity asset.

Would they like replacing their existing life insurance efficiently adding a LTCi benefit at the same time?

Have they discovered that they are uninsurable for LTCi but would like to pass some LTCi risk to an insurer?

All you have to do is find the opportunity.  Tell us what your client would like to accomplish; who is the insured or annuitant, the owner, and the beneficiary; the current value and the cost basis.

1035 exchanges move money without incurring taxation. That’s why, they are mostly relevant when there is a large gain in an asset.

1035 requirements:

  • Money must be from a non-qualified vehicle (but we can do some similar things with qualified money)
  • Must transfer directly between insurers
  • Old and new contracts must have exactly:
    • the same owners
    • the same insureds
  • Partial exchanges (only permitted from annuities) reduce cost basis & gain proportionately (Revenue Ruling 2003-51).

Furthermore, exchanges can be made only between the types of contracts shown in the following table.  The concept is that you can’t “increase risk” by moving from an annuity to life insurance.

These rules are not as limiting as you may think.

Consider: If your client or their spouse needs LTC, where will that money come from and what will be the tax consequences?  See Table 2.

The only non-taxable opportunity to obtain money from the above sources is the FIFO (first in, first out) ability to obtain cash value (up to cost basis) from a life insurance policy.  It is possible, however, that the cost of the LTC itself might be partially tax-deductible.  Housing, meals and amenities are not deductible.  Other expenses may be deductible but only to the degree that medical and dental expenses exceed 10% of adjusted gross income.

Alternatively, by doing a §1035 to a policy with LTC benefits, your client might be able to use pre-tax money to pay for LTC, avoiding a significant later tax burden.

We do §1035 exchanges where we:

  1. Move a traditional deferred annuity to a linked-benefit annuity.
  2. Secure some LTCi protection for someone who is severely height-challenged, has out-of-control diabetes, metastasized cancer, etc.
  3. Move to a single premium LTCi policy – entirely paid up with no chance of future price increases.
  4. Use one spouse’s annuity to get LTCi protection for both spouses
  5. Move traditional life insurance to combo life insurance.
  6. Use one spouse’s life insurance to get LTCi on both by using up to the cost basis for the non-insured spouse, then doing a §1035 exchange for the insured spouse.  The spouses could use their respective shares of the money very differently, if desired.
  7. As noted above, we’ve moved qualified money without subjecting all to current taxation, similar to a 1035 exchange except that it is not called a §1035 exchange.

Caution is appropriate.  The client should carefully weigh the advantages and disadvantages of a §1035 exchange:

  1. The new annuity may credit a lower interest rate than the current annuity.
  2. The new annuity charges for the LTCi rider.
  3. The old contract may have remaining surrender charges.
  4. The new contract may have much higher surrender charges, making the money less liquid after the exchange.

If healthy, the client might prefer to wait until surrender charges expire and annuity rates increase because of a higher interest rate environment or increasing age relative to an immediate annuity.  However, if extension of benefits is important; or existing credited rate or surrender charges are very low, or they fear a health change).

Value proposition: Do the tax break & LTCi benefits justify a lower future yield and higher temporary surrender charges?

For further reading, check out our entire repository of 1035 articles and guides by clicking here

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