Understanding 1035 exchanges

Shelly Gigante

By Shelly Gigante
Shelly Gigante specializes in personal finance issues. Her work has appeared in a variety of publications and news websites.
Posted on Jul 12, 2021


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If you own an annuity or cash value life insurance policy, but wish to protect your assets from the risk of rising long-term care costs, you may be in luck. Section 1035, a little known provision of the federal tax code, enables policyowners who meet certain requirements to trade in their existing contract or policy for long-term care insurance — tax free.

Indeed, the 1035 exchange provision has long allowed individuals to transfer funds from a non-qualified annuity (one purchased with after-tax dollars) to another annuity that may better meet their needs, or from a life insurance policy to an annuity or another life insurance policy without paying current income tax on the investment gains earned on the original contract. The Pension Protection Act of 2006 expanded 1035 exchanges to include qualified long-term care insurance starting in 2010. The provision also allows for the tax-free exchange of one qualified LTC policy for another, and for the exchange of an existing annuity or life insurance policy to an LTC policy.

Annuity owners can transfer funds either in part or in full for use in purchasing LTC insurance, leaving any portion that remains in their existing annuity. Those with life insurance, however, must exchange their entire policy when they execute a 1035 exchange, but only a portion of their exchange need be directed to the LTC policy. Whatever remains can be used to purchase another life insurance policy or annuity. Or, it can be taken as cash, which may trigger a taxable event.

Life insurance policyowners who complete a 1035 exchange may lose the death benefit and ability to access the cash value in their original contract. In some cases, a 1035 exchange from life insurance to LTC may not be practical, particularly if the cash value in the life insurance policy exceeds the LTC premium.

For that reason, 1035 exchanges from an annuity may be the easier solution. It bears noting, however, that when making the exchange from an annuity, one loses the ability to annuitize for a stream of income.

To qualify for tax-free treatment under a 1035 exchange, the funds must be transferred directly from the original insurance company to the new policy, not distributed first and then transferred.

Those who fund their LTC insurance premiums using proceeds from a 1035 exchange, and meet the requirements, would generally avoid taxation on the gains associated with the exchanged amounts. (There may be situations where the gains could be taxable, such as if the LTC provided a return of premium feature.)

By comparison, in an annuity, a portion of each payment would normally be subject to taxes once an annuity begins payments. The tax would be applied on the portion of each payment that represented gain. And the life insurance gains in excess of the cost basis (which is generally the sum of all premiums paid) that accumulate in the cash value portion of a policy are subject to ordinary income taxes when withdrawn (excluding loans or dividends previously taken).

Hence, the appeal of a 1035 exchange.

“In essence, you are able to pull out the accumulated interest that would have otherwise been taxed, and because you are using it to fund a long-term care policy, it is a tax-free transaction,” said Aaron Skloff, chief executive officer of Skloff Financial Group in Naples, Florida, in an interview. “That can be a good benefit, but you need to make sure that solution is appropriate for you.”

What is long-term care?

Long-term care describes a range of services and supports to assist individuals with functional or cognitive impairment to perform routine daily activities, such as eating, bathing, and dressing. Such care is typically administered through nursing homes, assisted living facilities, or home health aides.

Projections from the Urban Institute research group suggest that roughly half of today’s 65-year-olds will eventually need help with two or more “activities of daily living” during their lifetime or develop severe cognitive impairment.

Medicare and other private health insurance plans generally do not cover long-term care costs, which can be relatively expensive. A private nursing home room, for example, costs roughly $8,800 monthly, while those at assisted living facilities pay about $4,300 per month, according to the Genworth 2020 Cost of Care Study.

Long-term care insurance is designed to cover many of those expenses, but it, too, comes at a cost. Depending on the coverage selected, the American Association for Long-Term Care Insurance (“AALTCI”) reports a 60-year-old couple who qualifies for “preferred health” discounts would pay anywhere from $2,605 to $4,935 per year for a shared LTC insurance policy.

Most homeowners insure against the unlikely event of a fire, but few purchase long-term care coverage, Skloff observed.

But Skloff also noted that long-term care insurance may not be necessary if you have a family member who is willing and able to care for you, or the resources to pay for such care out of pocket. Conversely, those with minimal assets may also qualify for long-term care via Medicaid, the federal health insurance program for low-income and disabled individuals.

Those who wish to purchase LTC coverage, via a 1035 exchange or outright, should determine first whether they qualify.

Indeed, the AALTCI notes that there are a number of pre-existing health conditions that may make it impossible to obtain coverage, including dementia, kidney failure, Parkinson’s disease, and paralysis. Roughly 23 percent of applicants who are ages 60 and 69, 45 percent of applicants ages 70 to 79, and 70 percent of applicants 80 or older are denied LTC insurance coverage for health reasons, the AALTCI reports.

For whom might a 1035 Exchange make sense?

If you qualify for coverage, a 1035 exchange from an annuity, and potentially a life insurance policy, to long term care insurance may make sense under a few specific scenarios, said Skloff.

If your kids are now financially independent and you have adequate savings, for example, you may no longer need as much (or any) life insurance coverage as you originally purchased.

“You may have purchased life insurance when you were 40, and now you are 58 and you look at your situation and see that the last of your children is finally in a stable job, so your need for life insurance has maybe changed,” said Skloff. “Or maybe you are now more knowledgeable about long-term care costs. As you get older, you may need less life insurance, or you may need the same or more.”

Another potentially compelling reason to facilitate a 1035 exchange, for replacement LTC insurance or otherwise, is that products available today may offer more flexibility, better features, or lower costs due to improved health or mortality across the general population. Combination (hybrid) life and long term care insurance policies that combine the benefits of both, for example, are an increasingly popular product, said David Blount of Investment & Insurance Planning Services in Oviedo, Florida.

Thus, while the ability to avoid taxation of gains on your old annuity or life insurance contract is an obvious benefit of a 1035 exchange, the move may still make sense if your policy has not appreciated significantly in value, said Blount in an interview.

“It’s not always about tax avoidance,” he said. “It’s about transferring risk and getting the most benefit you can from your dollars. Anytime there is an insurable need and you can improve upon your coverage without losing money or coverage benefits, that is a great opportunity.”

For whom might a 1035 NOT pay off?

On the other hand, said Skloff, a 1035 exchange to LTC insurance may not be the wisest move if your health has declined since you purchased your life insurance policy, because that would result in higher premiums for a replacement policy that includes both life insurance and long-term care coverage.

“The reality is that if you have an existing product, the price was probably based on your age and health at the time and a new product will be based on your current age and health, which for most people means they would be paying more and getting less,” said Skloff, noting consumers should look to be sure a 1035 exchange serves their interests.

Life insurance policyowners should also be wary if they have an outstanding loan on their original policy, because a 1035 exchange could trigger taxes on the unpaid balance.

Before you execute a 1035 exchange, you should also look to be sure you will not be subject to early surrender charges in your old contract or policy, which can reduce the value available for the new policy.

It bears noting as well that not all long-term care insurance companies are willing to accept 1035 exchanges.

Annuity and life insurance policyowners considering a 1035 exchange should educate themselves on the pros and cons, and speak with a financial professional who can help them make an informed decision.

“If a person does not understand what they’re getting they should not make a change,” said Blount, noting it may not be necessary to exchange their policy at all. “If they foresee needing to use the benefits from their old annuity or life insurance contract they should keep what they have or look at options to change their coverage.”

1035 exchange alternatives

Life insurance policyowners, for example, could do a reduced paid-up policy, in which the existing cash value would be used to pay for the policy itself, which reduces the future death benefit, but also eliminates any ongoing premium, said Blount. They could also complete an analysis of their life insurance to determine whether it will likely run out, and, if so, agree to a higher premium to keep their current life insurance policy in force.

“Sometimes the policy they already own can be modified, and they don’t need to do a 1035 exchange,” said Blount. “It’s important to explore all your options when considering whether to keep life insurance — and that includes 1035 exchanges.”

Those with universal life insurance policies may also wish to complete an analysis of their current coverage to determine whether it is projected to last as long as it was originally intended — or lapse prematurely. Indeed, Blount said many such policies purchased 15 years ago or earlier assumed a 6 percent or greater growth rate, but as interest rates slowly fell, they may have paid out closer to 4 percent.

In some cases, the reduced account value means the policy could lapse earlier than expected. To ensure the policy remains in force, policyowners may need to increase their monthly premiums.

“The assumptions that your original policy was based on in determining the premiums may now be off,” said Blount. “It’s best to ask ahead of time whether the (account) value in your … universal life insurance policy is going to be sufficient to keep the policy in force, or whether you may be required to pay a higher premium so it lasts until maturity.”

With life expectancies on the rise, long-term care has become a bigger potential expense for older Americans. If you wish to help protect your retirement assets from the possible risk of nursing home or assisted living costs down the road, and your need for annuity income or life insurance has changed, a 1035 exchange is one option to consider.

Just be sure to check with a tax advisor or financial professional who can help you explore alternatives and determine whether such a move makes sense for you.

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The information provided is not written or intended as specific tax or legal advice. MassMutual, its employees and representatives are not authorized to give tax or legal advice. You are encouraged to seek advice from your own tax or legal counsel. Opinions expressed by those interviewed are their own and do not necessarily represent the views of MassMutual.