Life insurance is a critical financial safeguard for every individual and family. But as you age and your goals change, you might find yourself with a life insurance policy that is out of sync with your needs or goals.
When we conduct a comprehensive financial review with clients, it’s not uncommon to discover old life insurance policies that were purchased 10, 15, or even 25 years ago, put in a drawer, and never looked at again, because the client believed that they didn’t need to. However, insurance, like all aspects of our financial plans, should be reviewed regularly to ensure that your policies remain aligned with your planning goals and are performing as expected.
For example, as we move into middle age, planning for a potential long-term care event tends to become a very high priority. Without proper planning, the need for long-term care can result in stress about financials, especially for women, who typically need care longer than men. The loss of physical or cognitive independence is stressful on its own. Many of us want to spare ourselves and our loved ones the additional anxiety around money decisions such as who will pay for care and which assets are spent on care, as well as the emotional strain of care coordination and dealing with other family members who may be over-or under-involved.
If you have a life insurance policy that no longer suits your needs, you may want to consider a 1035 exchange as a way to help pay for future long-term care expenses.
What is a 1035 exchange?
A 1035 exchange is a provision from Section 1035 in the tax code that allows for a tax-free transfer of one life insurance policy to what the IRS terms a “like kind” (meaning similar) policy. There are some requirements to qualify for this exchange, including that the existing policy can only be exchanged for a new policy, and the owner and insured generally must be the same on both the old and new policies.
Keep in mind that 1035 exchange strategies are not one-size-fits-all. If you no longer need a life insurance policy, consider working with a professional to review all options and the ramifications of the different actions, including any surrender charges that might apply, and any tax impact of those options. These could include staying the course, exchanging the policies, surrendering the policies, or even life settlement.
You also want to check whether you’d be able to qualify for any new coverage you want before allowing an existing policy to lapse.
How a 1035 exchange can help with long-term care expenses
While there are some limitations on the types of policies you are permitted to exchange, a 1035 exchange generally allows you to exchange an existing life insurance policy to a long-term care insurance policy. One option for long-term care insurance is a hybrid long-term care policy (HLTC), which combines life insurance with a long-term care rider into one policy, allowing you to draw down or accelerate the death benefit to pay for any long-term care needs. Any qualifying long-term care expenses covered by the HLTC policy are paid tax-free.
Below are some scenarios in which you may want to consider moving from an outdated life insurance policy to a new HLTC policy. Talk to a tax professional to understand any tax implications of a 1035 exchange.
- You and your loved ones no longer need the death benefit amounts, and the policy is in jeopardy of lapsing unless you pay significantly higher premiums.
- The existing life insurance policy is not performing as expected. For example, premiums are increasing at increasing rates and if the policy is held to maturity, premiums paid would be higher than the actual death benefit.
- The difference between the policy’s death benefit and cash value is low. Insurance policies usually offer an illustration of how your policy is projected to perform in the future, or the internal rates of return (IRR). The IRR compares the cumulative premiums against the death benefit obtained in a hypothetical future year. This measurement is extremely helpful when analyzing the potential after-tax return of the policy.
- You believe you would qualify for a long-term care insurance policy, based on your current health status and age. For more on qualifying for long-term care insurance and other long-term care coverage options, read “Long-term care: Options and considerations.”
Consult with a professional
Planning for long-term care is an important challenge and having the right amount of insurance for your family at every stage is a critical part of a financial plan. You may want to consider consulting with a financial professional who can review your current insurance and help you decide what future coverage will work best for you and your family.
David is responsible for Fidelity's estate and wealth planning activities, including creation of new thought leadership in these areas. He heads a team of professionals that develops and delivers the depth and breadth of Fidelity's wealth planning offering.
Prior to joining Fidelity, David was managing director and head of Insured Solutions for UBS Wealth Management Americas. He served as chief operating officer of UBS Wealth Planning. David first joined UBS as a senior member of UBS Private Wealth Management, and was involved in the creation of that business for the firm. During his tenure with UBS, he also served as the chairman and president of UBS Life Insurance Company USA, Inc.; the chairman and president of UBS Financial Services Insurance Agency, Inc.; and a board member of UBS Trust Company, N.A.
Prior to joining UBS, David was a director in Merrill Lynch's Private Banking & Investment Group. He joined the firm's International Private Banking business in London and was a key member of the firm's Corporate Strategy unit.