Make sure you max fund first. In this episode, I'm going to address the
question what is the best way to do a 1035 exchange on a life insurance policy?
This will help you understand why many insurance agents do not do it correctly
or do not maximize the benefit of exchanging one life insurance policy for
a better one.
My name is Doug Andrew and I've been a financial strategist, retirement planning
specialist for more than 46 years. And I've helped thousands of people
determine which life insurance policies or contracts are going to be the best
for them to achieve their financial goals. I was never a captive agent with
any one company. I use several different companies. I usually had about 200 at my
disposal but there were generally between 6 to 12 that were my favorites
that I knew would perform best. And they treated their customers well. Sometimes
unfortunately many insurance companies will change things through the years on
the older policyholders. And they make it not so attractive
if you've sort of hung in there and I thought that was wrong. And so, many times
I would do an audit or a comparison to see if it would behoove someone to
replace, exchange an old outdated non-performing life insurance policy for
a better one. Now that could have been policies that they actually had taken
out through me 15 or 20 years earlier. Or maybe people came to me after they read
one of my books and got educated. And they wanted to exchange their life
insurance policy which maybe was designed primarily for death benefit. And
they learned about how you can use an indexed universal life more for living
benefits. And so, they wanted to exchange a policy, a life policy for another
policy that is provided under Section 1035 of the Internal Revenue Code hence
it is called a 1035 exchange. If you've ever heard of a 1031 exchange in real
estate, that's where you can sell one piece of property and buy another like
piece of property. And the money goes directly into the new property and you
don't have to pay tax. It continues to grow tax-deferred with real estate. With
life insurance is tax-free and your money will continue
to grow tax-free as it moves from the old policy to the new one. But there are
some very specific rules or things you need to consider if you're going to do
this. So, the first thing that I would strongly recommend is that with someone
who's proficient, they order an end force illustration from the insurance company
that issued the existing policy that you're considering doing a replacement.
You want to have an illustration so you could compare. And you want to make sure
It's an apples to apples comparison. Now, many people that would come to me and
they wanted to change the objective. So, you have to ask yourself, "When you took
out this insurance policy that you're looking at replacing, what was your
objective?" Many times it was just for the death benefit. Now, they want to change it
for living benefits. And they want a policy that will provide maybe double
the net spendable retirement income than their existing policy could ever
generate. Because it wasn't designed to do that. If you're wanting to maximum
fund a policy for living benefits, here is one consideration most insurance
agents do not understand. If you had an outdated universal life and it wasn't
performing very well and the insurance company was only crediting 3.5
or 4 percent and you know you could exchange it out and have a
universal life that is linked to an index where you could earn more like
8, 9 or 10 percent, hello? That's a no-brainer. You order an enforced
illustration showing what this would do even if you maximum fund it. If you threw
a bunch of money in there. And you take it out to age 65 or 70 whenever you're
going to retire and then you illustrate the the income that it would generate out to
age 90 or 100 or age 120. And what's interesting in these comparisons you'll
see that traditional IRAs and 401Ks and mutual funds, they crash and burn
because they're they're taxable. You want to see the net tax-free income.
When you look at that, you realize I want a better policy maybe. So, then you do a
1035 exchange. So, all of the years, all of the money that you put into the
old policy, you'll get credit for in the tax-free
grandfathering. So, if you were to cash in the policy, cash it out, surrender it and
then you put that money into the new policy, that is not a smart way to go
because you're having to start from scratch in the new policy and you have
to fund it over a minimum of 5 years to be able to access the money tax-free
under the Tamara law that I explained in other episodes. If you want to
grandfather yourself for the 2, 3, 4 10, 15 years that you
paid premiums into the old policy, you do a 1035. You can just change it now. You
can't take the money. The insurance company must send it directly to the new
insurance company. You can't touch it. When you do that, that money transfers
totally tax-free. Now, you want to make sure the cost of the new policy, the
acquisition costs are worth it and then you'll make up those acquisition costs
sooner than later. That's usually a no-brainer to analyze
that. But here's the secret that many insurance agents do not consider. If
you're looking to maximum fund it, under the IRS rules, we have Tefra, Defra and
Tamra tax citations that were passed back in 1982, 1984 and 1988. Tamra is the
one passed June 21st 1988 that made us slow the flow because there were a lot
of banks and brokerage firms that were whining back then. We can't compete with
these maximum-funded insurance policies. They pay higher interest, they're tax
free. They blossom when you die and on and on and on.
So, we don't want to kill them. Why? Because this is where they put some of
their money, okay? They wanted to slow the flow of money out of their institutions.
Because back before 1988, if I had a client that had a huge lump sum... Let's
say 500,000. I have many clients in the 1980s that could throw in
500,000 before 1988. They were earning 11 earning 10 percent and they
immediately started taking 50,000 a year of tax-free income, 10% of 500,000. After
1988, you couldn't do that. If you had a lump sum and you threw it into policy
and you took the least amount of insurance the IRS would let you get away
with under Tefra, Defra, it would grow tax-deferred. But if you started taking
income, it would be taxable LIFO, like an annuity. Last in first out.
That's money you're earning the interest every year is the first money coming out.
Now, when you die, it would transfer tax-free and the remainder. But if you
want tax-free income, Tamra said you have to spread it out if it's universal life
over usually about 5 years to be exact. If you put in 100,000
of the 500,000, the first day of the first year, you can put it in
the last 100,000 on the first day of the fifth year which is
technically 4 years and one day later. If you do that, 100,000 the
next year another 100, 100, 100, 100; you don't have to put that much in. Then you
can take out tax-free income the rest of your life. That's called the Tamra rule.
What does that have to do with this concept? If your old policy has already
had 5 years, those 5 years of water under the bridge,
you don't have to wait 5 years again. You can maximum fund, you could put in
the money in 1 fell swoop into the old policy which isn't going to perform well.
You don't want to leave it there. But you can maximum fund it if you have someone
who understands how to get those numbers. You could throw in a big lump sum of
money into the old policy. And then do a 1035 exchange immediately into the new
policy once it's approved. You have to wait till if the new one's approved. And
when you do that, now you've had all those 5 years of water under the
bridge taken care of. You hit the ground running and any other room you made, you
can then put in that money according to the Tamra guidelines. If you don't do
what I just said, you may have to start all over with the 5-year waiting
period because you didn't maximum fund the policy before you
the 1035 exchange. That is what many agents do not understand. So, if you have
an older policy that's underperforming and you want to consider a replacement
with a new better one, make sure you have an enforced illustration, you have a proper
comparison. And then if it makes sense to do it, you do it correctly and you
maximum fund it perhaps before you do the exchange if that's your objective
for the new policy. So, the takeaway here is to be careful but consider doing an
audit regularly on your insurance policies to see if it behooves you to do
a 1035 exchange. But I would recommend that you look at the best way to do that
and do it properly. I prefer maximum-funded indexed
universal life which I affectionately call the Laser Fund. Because lays remains
liquid asset safely earning returns. And so, this is my eleventh book on this
topic. "How to diversify and create the foundation for a tax-free retirement?"
Where every million bucks can generate a hundred thousand a year of tax-free
income for as long as you live. I would love to gift you free a copy of
this book. It's a 300-paged book comprised of charts and graphs and explanations. On
this side of the book is actually 12 chapters with 62 actual clients stories.
And so, if you go to laserfund.com and pay 595 shipping and handling, I'll pay
for the book and you'll also have options to get the audio version or some
video training whatever you would like. But start out by learning this for
yourself and consider if this is a better way for you to go.