Reasons Not to Exchange

There are also various reasons why replacement of an existing insurance policy may not be a good idea. Here are some reasons why...

  • Cash value built up in the original policy may be applied to the new life insurance policy's first year expenses, including commissions.

  • Life insurance policies (other than term policies) often include early surrender charges, which can reduce the amount of cash value available toward the new policy. The new policy will likely have its own new surrender charge schedule, which may extend beyond that of the original policy.

  • You may pay higher premiums if, for example, your health has declined since the purchase of the current policy.

  • The new policy typically will have a new contestability period 2-year period from the issuance of the new policy during which the insurance company could challenge a death claim based upon a misstatement on the application.

  • There may be unfavorable tax consequences caused by surrendering an existing policy, such as a potential tax on outstanding policy loans.

  • You should exchange your life insurance policy only when you determine, after knowing all of the facts that the exchange is better for you and not just better for the person who is trying to sell the policy to you.

  • Both variable life insurance and variable universal life insurance are securities. Those who offer these products must follow SEC, FINRA, and state securities regulations, in addition to stateinsurance law. This means that a broker must tell you the important facts about the pros and cons of the exchange. Your broker or insurance agent should recommend such an exchange only if it is in your best interest and only after evaluating your personal and financial situation and needs, tolerance for risk, and the financial ability to pay for the proposed insurance policy.

  • Your broker or insurance agent may recommend that you use insurance policy values, such as loans or withdrawals, to pay premiums for a new life insurance policy. This activity is generally called"financing" premiums. It may not be appropriate for you. For example, withdrawals from existing policies may be subject to federal income tax and may reduce the death benefit. Borrowing money from an existing policy will almost certainly reduce the death benefit. Withdrawals or loans may make it more difficult to keep the original policy in force without additional out-of-pocket premium payments. If you can't keep the original policy in force, you will lose the insurance protection and the loans themselves may give rise to tax consequences. Remember for a transaction to qualify as a 1035 exchange, the old policy must actually be exchanged for the new policy. Many states and brokerage firms require forms to reflect customer acknowledgement of a replacement transaction. These forms typically are signed by the insurance policy owner and the broker or agent. These forms may provide a comparison of the features and costs of an existing policy to a proposed policy, and point out what you need to focus on when considering an exchange. Some brokerage firms may provide brochures or educational material designed to outline the possible advantages and disadvantages of the transaction. You should review these forms and materials closely.

Regardless of anything you should ask the person recommending that you exchange or replace your existing policy to provide you with illustrations for your existing policy and the new policy. Make sure to ask the following: What is the total cost to me of the exchange? Which new features are being offered? Why do I need them? Are they worth the cost? Can the existing policy be modified or supplemented to provide some or all of these same features?

Reasons to Exchange 

There are various reasons why a life insurance policyholder may want to replace an existing policy with a new life insurance policy. For example, Improved health or mortality improvements across the general population may result in insurance coverage at a lower cost. You may have concerns with the solvency of the insurance company that issued the original policy or with the service of the agent that sold you the policy. A new life insurance policy may have more desirable features or benefits.


Should You Replace Your Life Insurance Policy?

If you have a life insurance policy, you may have been told that you may exchange it for another new policy. Even though the exchange income is tax free and the new policy may appear better to you, you may be losing. Life insurance exchanges may involve variable products which are securities, the following information will help you evaluate whether the exchange is right for you.

1035 Exchanges

The Internal Revenue Service allows you to exchange an insurance policy that you own for a new life insurance policy insuring the same person without paying tax on the investment gains earned on the original contract. This can be a substantial benefit. Because this is governed by Section 1035 of the Internal Revenue Code, these are called "1035 Exchanges." The tax code says that the old insurance policy must be exchanged for a new policy, you cannot receive a check and apply the proceeds to the purchase of a new insurance policy

You can make a tax-free exchange from
  1. a life insurance policy to another life insurance policy 

  2. a life insurance policy to an annuity. 

However, you cannot exchange an annuity contract for a life insurance policy. A transaction in which a new insurance or annuity contract is to be purchased using all or a portion of the proceeds of an existing  life insurance or annuity contract is referred to as a "replacement." A 1035 Exchange is a type of replacement transaction. Although the term "1035 Exchange" is often used to describe any form of replacement activity, technically not all replacements are Section 1035 Exchanges and as a consequence are not tax-free.

1035 exchanges
Life Insurance Exchanges

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