Tier One: Modernizing Your Existing Life Insurance Policy

Around six or seven times a year at Life Insurance Strategies Group, LLC, a policyholder requiring either more coverage or the need to reduce existing premium costs asks what they can do to achieve this goal.  Fortunately, policyholders are rarely stuck with the policy they initially purchased.   Just like your financial goals and personal situation evolve over time, so do the costs and features of new life insurance

Fortunately, tools like IRC Section 1035 exchanges and term life insurance conversions can help policyholders modernize their coverage without incurring tax consequences or undergoing medical exams. These strategies allow individuals to enhance their protection, reduce costs, and better align their policies with current objectives.

What Is an IRC Section 1035 Exchange?

IRC Section 1035 of the U.S. Internal Revenue Code allows for the tax-free exchange of certain life insurance or annuity contracts. It’s a useful solution for individuals who find their current policies lacking or outdated.

A 1035 exchange enables policyholders to directly transfer the cash value from an old policy into a new one, without triggering a taxable event. However, this must be done as a direct transfer between insurance companies. If funds pass through the policyholder’s hands, the IRS may disqualify the exchange, resulting in an unexpected tax bill.

Who Should Consider a 1035 Exchange?

A 1035 exchange isn’t for everyone, but it can be highly beneficial under certain circumstances:

• Your needs have changed: Life events like marriage, divorce, children, or a business venture can shift your priorities.

• Policy underperformance: If your existing policy offers weak returns or has high internal costs, a newer policy might provide better value.

• Estate planning updates: Changing estate sizes or goals may require more appropriate policy structures.

• Health improvements: If your health has improved since the original policy was issued, you might now qualify for lower premiums.

  
  

Eligible Policy Types for Exchange

Not all policies can be exchanged under Section 1035. Eligible exchanges include:

• Life insurance policies exchanged for other life insurance policies or annuities

• Endowment contracts exchanged for other endowments or annuities

• Annuities exchanged for other annuities (no, I’m afraid life insurance cannot be acquired in this direction)

  
  

While evaluating a new policy, it's crucial to assess potential surrender charges, new surrender periods, and whether underwriting is required.

Benefits of a 1035 Exchange

The biggest advantage is preserving the tax-deferred status of accumulated cash value. Additional benefits include:

• Enhanced features: New policies may offer living benefits like long-term care riders or higher guaranteed interest rates.

• Lower premiums: With improved underwriting or more efficient policy structures, some policyholders can reduce annual costs.

• Better estate planning tools: Policies can be tailored to meet current wealth transfer or legacy planning objectives.

  
  

Real-World Examples

Here are two scenarios demonstrating how 1035 exchanges have benefited actual policyholders:

Reducing Premiums on a Large Policy. A married couple in their late 50s owned a $40 million second-to-die policy with annual premiums of $567,834. Their policy had minimal cash value and offered a modest 3% return. By executing a 1035 exchange into a more competitive policy, they maintained their $40 million death benefit while reducing annual premiums to $286,428, a nearly a 50% savings. The new policy also credited a 5.35% interest rate on cash value.

Saving a Dwindling Policy. A 63-year-old policyholder had a $3 million universal life policy with $477,000 in cash value, but projections showed it would lapse in under 16 years unless premiums increased. By exchanging into a new policy, he secured the same $3 million death benefit at a reduced premium of $17,824 and projected longevity to age 101. At his expected life expectancy, the policy was forecasted to hold over $700,000 in cash value.

In both situations a 1035 exchange dramatically improved both cost-efficiency and longevity of coverage.

Understanding Term Life Insurance Conversions

In addition to exchanges, term life insurance conversions offer another path to upgrading your coverage. A conversion allows you to transform a term policy into a permanent policy; typically without a medical exam or proving insurability.

Not all term policies include this feature, so it’s important to review your contract or consult with a qualified insurance advisor.

Types of Convertible Term Policies

Convertible term policies usually allow conversion during a specific time frame or before a certain age. The permanent policy options available for conversion are typically predetermined by the insurance company. For example, you might only be able to convert into certain whole life or universal life policies offered by the same insurer.

How the Conversion Process Works

The process is relatively straightforward. The policyholder notifies the insurer of the intention to convert. Premiums for the new permanent policy will be based on the insured’s age at the time of conversion, not their health. This makes it a valuable tool for those whose health has declined but still want to secure lifelong coverage.

When Conversion Makes Sense

Term policyholders might consider converting if:

• Health changes make qualifying for new insurance difficult

• They want permanent coverage to ensure a death benefit no matter when they pass

• They're interested in cash value growth for supplemental retirement income or liquidity

• They wish to use life insurance as part of a long-term estate or charitable giving strategy

  
  

Key Benefits of Conversion

• Lifelong protection: Permanent policies never expire as long as premiums are paid.

• Cash value growth: Some policies allow for tax-deferred cash value accumulation that can be accessed while living.

• Stable premiums: Though higher than term premiums, permanent policy costs usually remain fixed.

• Estate planning advantages: Permanent insurance can help equalize inheritances or leave a lasting legacy.

Life Insurance is not a Passive Product

Life insurance isn't a "set it and forget it" financial product. As your life circumstances change, it’s important to periodically evaluate whether your existing coverage still serves your needs. Both IRC Section 1035 exchanges and term life conversions provide ways to optimize your life insurance without starting from scratch and without paying unnecessary taxes.

If you’re unsure whether your policy is still working for you, consider speaking with a life insurance professional who can help you analyze your options and recommend the best course of action.  

At Life Insurance Strategies Group, LLC, we do not sell products.   We help our affluent individual and institutional clients make complex decisions involving life insurance.   If we can help you, reach out to us through www.lifeinsurancestrategiesgroup.com.