When to Do a 1035 Exchange With Your Life Insurance

When you need to get rid of your life insurance, you have a few options. Canceling your policy outright may be a bad idea  if it's a permanent life insurance policy that has cash value. A 1035 exchange is the name of a special exchange authorized under IRS code section 1035 that allows you to side-step all of the negative tax consequences of canceling your policy, and it allows you to continue deferring income tax on all of the cash value you've accumulated. Here's when to talk to your agent about one:

When You Have A Cash Value Policy

The best time to utilize a 1035 exchange is when you have a cash value policy - like a whole life or universal life policy. These policies accumulate a cash reserve, called a cash value. That cash value represents money that will be used to pay the future death benefit. During your lifetime, however, they're available for you to use for any reason.

Unfortunately, if you cancel your policy for any reason, any gain on your cash value is subject to income tax. That's unfortunate because this money belongs to you. You should try to keep as much as you possibly can.

When Your Policy Is About To Collapse

Some life insurance policies don't pan out as expected. Unfortunately, many universal life policies from the 1980s had cash value projections that were too optimistic for the future. The high interest rate environment during that time caused life insurance companies to project double-digit growth in the cash value.

When interest rates fell in the 1990s, UL policies could not survive based on the projections made in the 1980s. As a result, many policies collapsed. Unfortunately, the insurance industry continued to develop products that rely on future interest rate projections that may or may not come true.

If your policy isn't doing well, and your cash value is decreasing, it might be time to abandon ship. You can switch to a life insurance policy with guaranteed features and interest rates (rather than assumed interest rates) or to a term life policy.

When You Need An Annuity

When you want an annuity, you can 1035 exchange the cash value inside your existing life insurance policy to the annuity. Annuities have unique features that life insurance policies don't have. Most notably, annuities can guarantee a lifetime income stream.

In principle, this is a sort of personal pension. You give the insurer a lump sum of money, and the insurer promises to pay you a fixed monthly payment for as long as you live - regardless of how long you live. Even if you otherwise would have run through your entire savings, the insurer keeps making payments.

There's an obvious benefit to this: you don't have to worry about the investment performance of your policy, and you don't have to constantly rebalance your portfolio. All you have to do is hand over the money and let the insurer do the rest. They become your professional money managers. Because insurers spread financial risk of loss out over millions of policyholders, they can guarantee that you'll never run out of money.

When You Find a Lower-Cost Policy

Sometimes you'll find a policy with a lower cost of ownership than the one you have now. When you want to replace your current policy, you must have your agent fill out replacement paperwork. You'll receive a spreadsheet containing a comparison of your current policy and the new proposed policy.

From there, you can analyze the costs of your current policy against the new policy. If the new policy is cheaper, or if it offers some benefit you want or need that your current policy doesn't offer, then a switch might be appropriate. Use a 1035 exchange, and you'll roll smoothly into your new contract without any tax liability.

Your Long-Term Goals Have Changed

If you originally purchased a life insurance policy to help supplement your future retirement, but you no longer need the funds, you can switch your policy to one that provides more death benefit. Typically, life insurance policies that are used to supplement retirement benefits provide you with a low death benefit relative to the cash value and premium payments, but offer you a higher cash value than you would otherwise get with a straight whole life or a traditional universal life policy.

If all you need is inexpensive lifetime insurance protection, consider a universal life policy with secondary guarantees or a low cash value whole life policy that blends term life with whole life for low-cost coverage. Using the existing cash value, you may even be able to fully fund the new policy without any additional premium outlay on your part.

Alternatively you can just get a cheap term life policy at a low cost and save money on what you are currently paying.