Does a 1035 Exchange Avoid Surrender Charges?

A 1035 exchange allows for the tax-free transfer of funds from one life insurance policy or annuity contract to another, or certain other qualified contracts. This provision of the Internal Revenue Code is important when considering associated fees known as surrender charges. This article clarifies how 1035 exchanges interact with surrender charges.

The Basics of a 1035 Exchange

A 1035 exchange, defined by Internal Revenue Code Section 1035, permits the tax-free transfer of funds between specific types of insurance products. Its purpose is to allow policyholders to move accumulated gains from one contract to another without immediate income tax liability, enabling them to update financial plans or secure a more suitable contract.

This provision applies to several like-kind exchanges: a life insurance policy for another life insurance policy, an annuity contract for another annuity contract, or a life insurance policy for an annuity contract. Exchanges from life insurance policies or annuity contracts into long-term care insurance policies are permitted. However, an annuity contract for a life insurance policy is not allowed. The benefit of a 1035 exchange is tax deferral, meaning growth within the original policy continues to grow tax-deferred within the new policy until withdrawals are made or the policy matures.

The Nature of Surrender Charges

Surrender charges are fees imposed by insurance companies when a policyholder withdraws cash value from, or fully surrenders, a life insurance policy or annuity contract within a specified period after its purchase. These charges are outlined within the policy contract. Their purpose is to help the insurance company recover initial costs associated with issuing the policy, including sales commissions, underwriting expenses, and administrative setup.

Surrender charges function on a declining schedule over a defined “surrender period,” which ranges from 5 to 10 years, and can extend up to 15 years. For instance, a charge might start at 7% or 8% in the first year and decrease by one percentage point annually, eventually reaching zero. This fee is calculated as a percentage of the premium paid or the cash value being surrendered. Many contracts allow for a small percentage, often 10% of the cash value, to be withdrawn annually without incurring a surrender charge.

The Interaction of 1035 Exchanges and Surrender Charges

A 1035 exchange does not eliminate or avoid the surrender charge on the original policy. When a policyholder initiates a 1035 exchange, any applicable surrender charges on the existing policy are deducted from its cash value. This deduction occurs before the remaining net cash value is transferred to the new policy.

The tax-free nature of the 1035 exchange applies to the transfer of this net cash value, not to the avoidance of the surrender charge itself. Even though the exchange defers taxes on accumulated gains, the amount moved to the new contract is the cash value of the old policy minus any outstanding surrender charges. Consequently, the policyholder receives a reduced amount in the new contract, and the surrender charge remains a cost of exiting the old contract early.

A new policy acquired through a 1035 exchange will come with its own new surrender charge period and associated fees. This means that even if the surrender period on the original policy has expired, the policyholder may enter a fresh period during which surrendering the newly acquired policy would incur new fees. The new contract’s surrender schedule might differ from the old one, potentially extending the period during which such charges apply.

Factors to Understand When Considering an Exchange

When considering a 1035 exchange, policyholders should focus on the implications for the new contract and their overall financial situation. The new policy will impose a new surrender charge period, which resets liquidity for a number of years, ranging from 7 to 10 years. This new period means funds transferred into the new policy may be subject to new fees if withdrawn early.

The new contract can also introduce different fee structures compared to the previous policy. These include varying annual fees, mortality and expense charges, administrative costs, or charges for riders. Policyholders should compare these costs to ensure the new policy aligns with their financial objectives. The new policy can offer different features, such as new investment options, death benefit guarantees, or living benefits. Evaluating how these features align with current and future financial goals is necessary, as they impact the long-term value and utility of the contract.