Ep. 14: Demystifying 1035 Exchanges: Your Ultimate Guide to Insurance Contract Transfers
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1035 Exchanges, or Rollovers, are an underutilized provision of the Internal Revenue Code which allows owners of annuities or life insurance policies to roll them over on a tax-free basis for brand-new policies with added features and benefits.
Listen in as Ted dives deep into how to take advantage of yet another powerful tool to avoid having to pay a penny more in taxes than you need, and build more wealth all the while!
Offering actual examples of transferring one annuity or life insurance policy for another, Ted demonstrates that a 1035 Tax-Free Exchange is one of the best options out there to help navigate the rising costs of long-term care, even if you’re already at retirement age!
- Transferring your annuity or life insurance into a new policy (2:24)
- Why you can’t roll an annuity into a life insurance policy (3:37)
- An example of exchanging one annuity for a better one (05:52)
- Benefitting from rolling over an existing deferred annuity at the age of 65 and up (12:10)
- Adding your spouse as a joint insured to the annuity or long-term care policy (15:28)
- An example of exchanging one whole life policy for another with a rider (16:10)
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This is episode 14, 1035 like kind exchanges, I would like to call them like kind rollovers. Today, we are going to talk about a very underutilized provision of the internal revenue code that allows owners of annuities, or life insurance policies to roll them over on a tax free basis for brand new policies that have added features and benefits.
Well, I hope you are all doing well today. It is a beautiful, brisk yet sunny spring day here in Clayton, Ohio, at the studios of Gudorf Law Group. Today, Sunday, we have an opportunity to once again continue our understanding of how we can save taxes, and overall improve our position. You know why I think every single one of us would acknowledge that in order to have a free country, it is important for all of us to pay a little bit in federal income tax or at least some form of taxation. Having said that, there is certainly no obligation on any one of us to ever have to pay a penny more than what we are legally obligated to do. You know, when I took tax in law school, my professor indicated to me that not any one of us is obligated to pay one penny more than what the law requires us to do. Furthermore, what we learned in law school was that the tax code is really a policy document. That is the code, the Internal Revenue Code, picks winners and losers, and today we are going to talk about some winners, and these are those of you who in the past have purchased an annuity contract, whether it be a fixed annuity, a variable annuity, an indexed annuity, or whether you have purchased a cash value life insurance policy, whether that be a whole life policy, or whether that be a universal life policy, or a variable universal life policy, or perhaps you have purchased a long term care product, or an endowment. The bottom line is, is that the Internal Revenue Code is going to allow you as the owner of that annuity or life insurance contract to transfer it to a new policy, and it will allow you to utilize an annuity to purchase another annuity. It will allow you to transfer an existing life insurance policy and purchase a new life insurance policy. It will even allow you to take a life insurance policy and roll that into an annuity product.
Now the only thing you are not going to be able to do is to take an annuity and transfer it into a life insurance policy. That is not allowed, and if you think about the underlying policy reasons, there is a reason why you cannot take an annuity and convert it to life insurance. Let me digress just for a moment and talk briefly about that. You see when you purchase an annuity product, most of the time that annuity is going to defer that tax on any gain until such time as you withdraw it either during your lifetime or when it is paid out to your beneficiary. When it gets pulled out of the annuity, the gain, not the principal, but the gain is taxed as ordinary income under the higher ordinary income tax rates, just remember, an annuity is not taxed at capital gains tax rates. It is one of the downsides to having gain inside of annuity. The upside is the tax is deferred during the lifetime of the annuity. The downside? When it comes out, it gets subject to ordinary income tax rates. Today, we have a marginal tax rates, where the lowest tax bracket is at 10%, and the highest is at 37%. Just remember, on January 1 of 2026, these marginal tax brackets are all going to change because the Trump tax breaks are going to expire, and therefore the rates are going to go back up with the highest rate being the 39.6% tax bracket.
Now, having said that, let us go back to understand what we are doing and why we might want to do it. Give me an example. If you have a simple deferred annuity that is paying, let us say 4% interest, but that annuity does not have any other features to it, including any other long term care features. Well, maybe now you are older, and you would like to exchange that plain Jane 3% or 4% deferred annuity into a new annuity that has a long-term care rider attached to it, I am going to show you in a little bit how you can do that. Perhaps you have a life insurance policy, let us say it is a universal life policy, and you purchased it 30 years ago, and it has cash value inside of it, and you have heard that the life expectancy tables have gone up, which show us living longer, and you wonder whether if you took the cash value in the old policy, despite you being older, you roll it over and exchange it into a new life insurance policy simply because it has a higher death benefit, because of the new life expectancy tables. Yeah, that is possible. I recently had a client who had a life insurance policy and he was paying a pretty significant premium for well over 25 years, he was paying about $14,000 per year, but he bought it a long time ago and the death benefit was $950,000. When we looked at just simply exchanging that cash value into a new policy, he was able to get more than double that death benefit, even if he kept the premium at the $14,000 level.
Now one thing is absolutely critical when we are doing a like-kind exchange of either an annuity or a life insurance product, that is that the ownership must be identical. That is if we have a joint annuity or a second-to-die life insurance policy under a husband and wife’s both names, then the new policy must be identical. It must be in either the sole name or their joint names, depending upon how the original policy was issued. That is a critical, critical question. Now if we have a circumstance where we have a joint policy, and one of the spouses has passed away, we are allowed to do a rollover of that amount if the first spouse has passed away. So, that is hopefully an example of how we can roll over or exchange an older annuity or life policy into a new one. I have an example that I would like to share with you. First, what I am going to do is I am going to share an annuity story with you, and then I will give you an example of a life policy and both of these instances are going to illustrate what we are able to achieve on the long term care site. For those of you who in the past, who did not want to be in the market, but instead decided that you wanted to pursue and purchase an annuity. Some of you have substantial numbers of annuities. Why? Because you did not want to be in the market. You never wanted to lose any money, and the annuity product afforded you that opportunity. And now though, you are older, and you are thinking about how can I get long term care to cover the increase in the rising cost of long term care, whether this be care at home, or care in the assisted living, or care in a nursing home, we all know that the costs have gone up rather significantly. I have a client right now. She has dementia. She is at 1 Linkin Park and Kettering, and her monthly rent is roughly $5,000. Now she has long term care being provided to her 24 hours a day seven days a week by aides, not nurses. That is costing that family $240,000 per year for that aide to come in, it is actually three aides to come in on a 24-hour seven-day a week basis. So, you can see how costly this long term care can be. Now, in order to do the exchange or the rollover into a new annuity, or a new life policy that has long term care benefits associated with it, there is a degree of medical underwriting. Now you will see that the underwriting pertaining to the annuity product is significantly less than the underwriting for the life insurance policy. Because the underwriting is left on the annuity, you do not have to be quite as healthy in order to get it. Having said that, I am going to show you an example where the long term care benefit is not as good on the annuity product as a life insurance policy because the life insurance policy, if you can qualify for that, at an older age, it is going to give you the biggest bang for the buck, and it should because you are healthier.
On the other hand, just because you are not fully fit does not mean you cannot get long term care, and that is really the message of the day today. We are going to show you a way to leverage your annuity into a new product that has long term care despite the fact that you might be 65, 75 years old, and you may have a few health problems. So, my simple example that I have illustrated is something like this, let us say that you purchased an annuity many years ago, and you put $50,000 in it, and over the course of time that annuity has performed well, and it has $50,000 worth of gain in it so that the cash value in the policy is $100,000, and let us say that that annuity product would be held for a period of time, let us say 15 years at 4% interest, where we get an additional $130,000 worth of gain, so that the total cash value that we are going to have from the $50,000 basis ends up being $180,000 of cash value. Well, if that annuity was cashed out, and we were going to pay a 21% tax rate, and that is arbitrary, I just pick that number, that tax on that annuity will be $27,319, and you would have $152,775 available for long term care. Now, instead of doing that, let us say we do this, let us say we take that existing annuity that is got the $50,000 basis and a $50,000 gain or $100,000 cash value, and we purchase a long term care annuity, again a deferred annuity that has long term care riders attached to it. What do we get? We are able to give you a long term care policy that has a long term care benefit of $323,922 available for long term care, and by the way, when it is paid for long term care, the tax is zero, no tax when it is paid out for long term care benefits. So, if you hold on to the annuity, if it gets 4% interest, 15 years goes by, you get 152,000 for long term care. On the other hand, if you buy the long-term care annuity at age 65, you are going to get $323,922. If you are younger than 65, you will get more, if you are older than 65, you are going to get a little bit less. But you can see, just by rolling over that existing deferred annuity, we are able to more than double the amount of money available for long term care, and that can occur even if you are having some health issues.
One of the other factors that I want you to think about is that even though when we do an annuity and exchange it and it has got to be in the same name, we are allowed to add the spouse as a joint insured to the annuity, long term care policy, that is significant that we can add our spouses to the policy. Of course, the long term care benefits are going to be adjusted by adding that spouse, but that is really a homerun. Let me go through an example involving not an annuity product, let me get into an example involving whole life, and what we are going to do is we are going to roll it over into a new whole life policy that has long term care benefits attached to it through a rider, and we are going to exchange it on a tax free basis. My example, again, like the annuity is going to consist of a 65-year-old male. So, let us assume that the initial premium is $100,000, and because it is a life policy, let us assume that it is going to have a death benefit of $149,000, but where this policy really sings, is on the total initial long term care benefit. The first 25 months, the long term care company is going to basically return your premium to you, but then they are going to provide an additional continuation of benefits for 50 months. So, that the total long term care benefit over this period of time ends up being $447,231. Think about that, for a 65-year-old, who has a life policy where they had an initial premium of 100 grand, that has a death benefit of 149, we are now able to exchange that into a policy that is going to pay $447,231 of long term care benefits, that is $5,963 per month, for 75 months, and remember, again, as those long term care benefits are paid out, those benefits come out tax free. So, it is critically important that we consider what we are doing with our older annuity products. Again, whether it be a fixed annuity, typically a fixed deferred annuity, or whether it be a variable annuity. Also, let us take a look at our life insurance policies, whether it be universal life or whole life, let us take a look at the cash value we have in there. Most of us do not need those policies during our lifetime, unless we need long term care, and if we are going to use it for long term care, let us exchange those policies and leverage that existing cash value into a much better product that has a long term care benefit associated with it, and just remember, most of our clients will do these kinds of exchanges or rollovers after they retire. So, after the age of 65, we recently had a couple come in and do this at the age of 77, and still received significant leverage by doing the 1035 tax free exchange.
Well, I hope you found this conversation enlightening. I hope it will provide you with some clarity and enable you to have some confidence with respect to being able to move forward to make sure we have got sufficient long term care benefits on our side. In the event, we end up being one of those 70% of the adult population who is going to need some long term care for a significant period of time.
Well, this is Ted Gudorf signing off for now. I hope you have a great day. Thanks for being with me.