1035 Exchanges: What Boards Should Test Before They Replace a Life Insurance Policy

What to compare, who has to sign, and what the exchange costs before a split dollar, SERP, 457(f) or bonus plan policy is replaced.

Before you sign. The tax break on a 1035 exchange covers the gain in the old policy. Whether the new policy is better is a separate question, and the vendor proposing it usually has a financial incentive for the exchange to go through. Have someone with no stake in the outcome check the comparison, and get it in front of counsel, the auditor and the participant’s tax or financial advisor before anything is signed.

Why this matters

Split dollar arrangements, SERPs, 457(f) plans and restricted bonus plans funded with life insurance often run for 20 or 30 years. The products and crediting rates behind them change along the way. At some point a vendor will propose replacing the policy, and the proposal will almost always arrive as a 1035 exchange.

Section 1035 settles one question: whether the gain in the old policy is taxed when it moves. It says nothing about whether the new policy is better. In these plans, the party that owns the policy is rarely the only one who lives with the result. An employer may exchange a policy that backs a participant’s death benefit. A participant may exchange a policy the employer holds as collateral, or one the employer restricts under a bonus agreement.

The board’s job is to decide on a fair comparison: what the plan has now, what it would give up, and what it would take on. This article covers how to set up that comparison, who has to agree, the tax and liquidity costs, and what changes when the exchange moves to a different product type.

What Section 1035 does and does not do

Section 1035 lets one life policy be exchanged for another life policy, an annuity, or a qualified long-term care contract without recognizing the gain. (26 U.S.C. §1035) It runs one way: an annuity cannot be exchanged back into life insurance tax-free. (26 CFR §1.1035-1)

The conditions are narrow:

• The insured stays the same.
• The owner stays the same. A change to a trust or other owner cannot ride on the exchange.
• The value moves carrier to carrier by assignment. If the owner takes a check, the exchange is lost.
• Cash or other property received in the exchange, including a loan paid off in the process, is taxable to the extent of gain.

That is the whole protection. Everything else is a business decision the board has to test.

Start with keep, modify, or replace

A replacement proposal usually puts a new illustration next to the old policy on its current path, or next to nothing at all. A fair comparison puts three options on the same future funding and the same objective:

• Keep. The existing policy as it stands, on an in-force illustration from its own carrier, at current and guaranteed assumptions.
• Modify. The existing policy adjusted: premium changes, a face reduction, a death benefit option change, loan repayment, a reduced paid-up election, or a new allocation.
• Replace. The proposed policy, funded with the net amount that would actually transfer after surrender charges, loan payoff and tax.

The horizon matters. In one set of illustrations we ran, a VUL indexed account was ahead of an IUL from the same carrier at year 20, and the IUL was ahead from year 30 on, at the same assumed rate.

Many in-force problems can be fixed inside the existing policy. If the case for replacing rests on the new illustration alone, it is weak.

Who decides and who bears it

The policy owner signs the exchange, but in these plans the owner is rarely the only party with an interest in the policy.

In employer-owned plans, the participant has to be on board. They sign the application, go through underwriting again, and usually consent under the agreement. Signing makes them a party to the decision, but it does not mean they understand it, so they should see the same comparison the board sees.

In participant-owned plans, the employer’s interest has to move with the policy. The split dollar assignment or the bonus restriction must be released and re-filed on the new policy without a gap. Grandfathered split dollar arrangements need counsel’s view before any exchange (see Notes).

Tax: basis, boot and MEC status

The old policy’s cost basis carries over to the new one. Get a gain and basis figure from the existing carrier, and have the owner’s tax advisor confirm it before the exchange is submitted.

Boot is how an otherwise tax-free exchange ends up with taxable income. It matters here because the policies being replaced are often the ones that have been used: borrowed against for retirement income, or drawn down to repay an employer.

• A loan paid off in the exchange is taxable, up to the gain in the policy. If the new carrier accepts the full loan, there is no boot.
• A withdrawal taken just before the exchange to pay down the loan can be treated as boot. The IRS has combined the two steps in private rulings. There is no safe waiting period, and some carriers apply their own lookback.
• Repaying the loan with outside money first avoids the issue.

Take an old policy with $500,000 of cash value, a $200,000 loan and $250,000 of basis. If the new carrier accepts the loan, nothing is taxed. If the loan is paid off with policy values in the exchange, $200,000 is taxable. If the owner repays it from outside funds first, nothing is taxed and the full $500,000 moves.

This lands hardest in loan regime split dollar plans in retirement, where participants have borrowed for income, and at rollout, when policy values are used to repay the employer just before an exchange.

A non-MEC policy is retested under a new 7-pay test after the exchange. Exchanged value alone generally does not create a MEC, but a lower face amount or new premium added at the exchange can. A policy that is already a MEC stays a MEC after the exchange.

Liquidity and protections

An exchange can carry two surrender costs: the charge to leave the old policy and a new schedule on the new one. A seasoned policy may have no surrender charge left. The new one typically starts a 9- to 15-year schedule at its highest point, so value that was fully available can become partly locked up again. Compare net surrender value at years 1, 5 and 10 as a share of what transferred.

For employer-owned policies, surrender value is the balance sheet. Institutions generally carry this insurance at cash surrender value, so a new surrender schedule can show up as a drop in the asset on the day of the exchange. (FDIC) Surrender charge waivers on the old policy do not always apply to a 1035 exchange, and enhancement riders on the new one often exclude a later exchange out. Banking guidance treats an exchange as a new purchase, so the original pre-purchase diligence applies again.

Other protections start over or need to be confirmed:

• Contestability and suicide periods generally reset, typically for two years. Some carriers waive or limit this on an exchange. Confirm it in writing.
• Underwriting is done again at the insured’s current age and health.
• Employer-owned notice and consent (Section 101(j)) carries over unless the exchange materially changes the contract, for example a material increase in death benefit. A change of carrier alone is not a material change. Even with a material change, new consent is not needed if the original one is still in effect, generally within a year of signing and while the insured is still employed. (SOA, on Notice 2009-48)
• Insurable interest is tested again under state law, which can limit exchanges on former employees.

Do not count on state replacement rules to produce the comparison. For example, Massachusetts exempts insurance paid wholly or partly by the insured’s employer from its replacement requirements (211 CMR 34.03(1)(e)), and other states have similar exemptions. In an employer-funded plan, the board has to ask for the comparison itself.

When the product type changes

Whole life puts most of the pricing risk on the carrier. Indexed and variable universal life move it to the owner. An exchange across product types is a decision to take that risk back.

This is a simplified comparison. Actual exposure depends on each contract’s guarantees, charges, allocations and loans.

IUL buy-ups and VUL indexed accounts with asset charges make the same trade: a fixed charge every year for a higher cap or participation rate, so a flat index year loses money.

What to understand before crossing product types:

• The crediting terms are the largest risk. Illustrations hold today’s cap, participation rate or dividend scale fixed for life. The carrier can lower caps and participation rates to the contract minimums, which were a 4% cap and 25% participation in the VUL we reviewed. Caps also amplify rate changes: in the product we modeled, a 1-point drop in the carrier’s yield takes a 10.5% cap to about 7.3%.
• Asset-charged accounts have a hurdle. The uncapped VUL account had to earn about 3.1 points more than the classic account just to keep up, whatever rate is assumed. At the illustrated maximums, that meant 9.71% against 6.59%, confirmed by a carrier ledger.
• The illustration rules differ. An IUL illustration is limited by AG 49-A. A VUL illustration falls under FINRA Rule 2211, which allows any gross rate up to 12% alongside a 0% illustration and one at maximum charges, and bars using hypothetical rates to predict results. (FINRA Rule 2211)
• Indexed loans add a spread risk. AG 49-A limits an IUL illustration to crediting an indexed loan 0.50% above the loan rate. The VUL we reviewed allowed 1.00% and illustrated 0.62%. The account can credit as little as 1%, so in a flat year the cost is 4 to 5 points on the full loan balance.
• Illustrated income held up in about half our scenarios. In our simulations, each design’s illustrated retirement income lasted to age 100 in roughly half of scenarios (see Notes).

Questions to answer before signing

1. What problem with the existing policy does the exchange solve, and was keeping or modifying it tested on the same funding?
2. Who owns the policy, who has to consent, and which plan documents and assignments have to be amended or re-filed?
3. Has the participant seen the full comparison before signing the new application?
4. What is the gain and basis in the existing policy, and has the tax advisor confirmed it?
5. Is there a loan, will the new carrier accept all of it, and were any withdrawals taken in the months before the exchange?
6. Will the new contract be a MEC?
7. What surrender charge applies on the way out, and what is the net surrender value of the new policy at years 1, 5 and 10?
8. For employer-owned policies, what happens to the carrying value on the day of the exchange?
9. Do contestability and suicide periods restart, and does Section 101(j) or state insurable interest law require new consent?
10. What guarantees in the existing policy are given up?
11. What does the new policy show at guaranteed charges and the minimum cap or participation rate, and without any asset-charged account?
12. Does the illustrated income still hold at a lower rate, and with the crediting terms cut?
13. How is the recommending vendor paid on the new policy?
14. Have counsel and the auditor reviewed it?

Closing

A 1035 exchange is a tax tool. Whether the replacement makes sense is a separate question, and in an executive benefit plan it has two answers: one for the employer and one for the participant. Each side should be able to say who now bears the investment, expense and mortality risk, what happens if the carrier’s current assumptions do not hold, and what the exchange costs in tax, surrender value and protections that start over.

The organization’s counsel and auditor, and the participant’s own tax or financial advisor, should see the exchange before it is submitted. An independent review of keeping, modifying and replacing, by someone who is not paid on the outcome, gives them a fair comparison to work from.

Notes

1. Rulings behind the mechanics

• Single life policies cannot be combined into a survivorship policy (PLR 9542037). A survivorship policy after the first death can be exchanged for a single life policy on the survivor (PLRs 9248013, 9330040).
• Value cannot be exchanged into a life policy already in force (PLR 8810010).
• Rev. Rul. 2007-24 treated a carrier check endorsed over to the new carrier as a surrender, not an exchange.
• Relief from a loan in an exchange is boot (Rev. Rul. 2003-56 reasoning). A loan carried over in full is not (PLRs 8806058, 8604033).
• A withdrawal used to pay down a loan shortly before an exchange was treated as boot under the step transaction doctrine (PLRs 8905004, 9141025). A withdrawal from the new policy after the exchange was not (PLR 8816015).

2. Boot: the same policy four ways

Old policy: $500,000 cash value, $200,000 loan, $250,000 basis, $250,000 gain.

Basis in the new policy equals the old basis, less boot received, plus gain recognized.

3. Grandfathered split dollar

Arrangements entered into before September 18, 2003 keep their earlier tax treatment unless materially modified. Notice 2008-42 lists changes to the arrangement that are not material modifications, but it does not address replacing the policy itself. (IRS Notice 2008-42) Whether an exchange is a material modification is unsettled, so counsel should weigh in first.

4. The VUL indexed accounts on the same funding

Illustrations of one VUL: male 45, standard non-tobacco, $1,000,000 a year for seven years, $13.25 million initial death benefit, all premium in one indexed account. Asset charges are deducted in the ledger values, not in the illustrated rate.

Illustrated with the indexed loan, the uncapped policy supported about 9.6% more annual income than with traditional loans, because the loan account was assumed to earn 6.62% against a 6.00% loan rate. At age 85 the indexed loan version had $3.9 million of cash value left, against $8.7 million.

5. How reliable is illustrated income?

We calibrated models to the carrier ledgers for whole life, an IUL, and the VUL classic and uncapped index fixed accounts, all on the same funding, with income from age 66 to 85. We ran 10,000 scenarios. Stock returns came from 1950 to 2025 history (“strong”) or a 6.5% average (“modest”). Interest rates came from carrier dividend and general account yield history, which also drove the caps and participation rates. The table shows the income each design supports in 95% of simulated scenarios, under these assumptions, through age 100.

The same income is taken every year from age 66 to 85, with no cuts after bad years. Taxes are not modeled, and charges stay at the carrier’s current levels. The carrier illustrated income only for the whole life and VUL uncapped designs; for the IUL and VUL classic, we calculated it using the same method.

6. Processing risk

In Branch Banking & Trust Co. v. Pacific Life (6th Cir. 2016), an exchange of a variable policy was delayed for weeks over a signature requirement while the market fell, costing about $260,000 in value. The owner recovered only through litigation. Confirm signature and authority requirements in advance, consider moving variable values to a fixed option before submitting, and keep the old policy in force until the new one is issued.

Sources

• 26 U.S.C. §1035
• 26 CFR §1.1035-1
• Rulings cited: Rev. Rul. 2003-56, Rev. Rul. 2007-24; PLRs 8604033, 8806058, 8810010, 8816015, 8905004, 9141025, 9248013, 9330040, 9542037
• IRS Notice 2008-42
• Society of Actuaries, Taxing Times on Notice 2009-48 Q&A-15 and Q&A-16
• 211 CMR 34.00, Replacement of Life Insurance and Annuities
• FDIC, Interagency Statement on the Purchase and Risk Management of Life Insurance
• FINRA Rule 2211
• NAIC, Life Insurance Illustrations
• Branch Banking & Trust Co. v. Pacific Life Ins. Co., No. 14-5871 (6th Cir. Apr. 12, 2016)
• Carrier illustrations of whole life, IUL and VUL on the same insured and funding, October and November 2026; dividend and general account yield history for six mutual carriers, 1995 to 2026