Ten checks before you exchange a policy and when to say no

Most advice about a 1035 exchange explains how to do one. This is the opposite: ten checks to run before you apply, each with the reason it is on the list, and a plain statement of what answer should make you stop. An exchange is a legitimate tool, and sometimes the best one. It is also the transaction in which a policyholder gives up a contract with a known history for a new one with a sales presentation attached, so the burden of proof belongs on the new contract.

Keep this list next to the 1035 exchanges: swapping policies without tax guide, which explains what the tax law allows. Tax-free is not the same as wise. A swap can defer tax and still leave you with higher costs, weaker guarantees and a fresh set of waiting periods.

How to use the list

Run the checks in order, in writing, and answer each with a number or a yes or no. Where the answer depends on a document, ask for the document. If you are working with an agent, give them the list and ask them to fill it in. If they cannot or will not, that is information.

For each check, the "say no if" line gives the answer that should pause the exchange. A single stop is not always fatal, but more than one is a strong reason to keep what you have, or to look at an alternative such as reducing the death benefit or using nonforfeiture options.

The ten checks

Check 1: What exactly is wrong with the policy you have?

Why it matters. An exchange should solve a named problem: premiums you cannot sustain, a policy that no longer fits your needs, charges you can show are high, a death benefit you no longer want, or a wish to turn cash value into income or long-term care coverage. "The new one is better" is not a problem statement.

Ask. What does the new contract do that the old one cannot, and can that be done without replacing? Could the same result come from changing the death benefit, a reduced paid-up option, or a rider?

Say no if the reason is a general feeling, a marketing pitch, or "everyone is moving to this product."

Check 2: What will the old policy charge you to leave?

Why it matters. Many policies carry a surrender charge for a set number of years. An exchange can trigger it even though it is tax-free. The charge reduces the value that moves, so you start the new contract behind.

Ask. What is the surrender charge today, when does it end, and does it apply to a 1035 exchange? Would waiting a year or two change it materially?

Say no if the charge is large, falls in a year or two, and nothing urgent forces you to move now.

Check 3: What will the new policy charge you?

Why it matters. A new contract usually starts a new surrender schedule and pays a new commission. Those costs are real even if they are built into the product rather than billed. A lower premium alone does not show that the contract is cheaper if the new one has higher internal charges or lower guarantees.

Ask. For the new contract, what is the surrender schedule, what are the guaranteed charges, and what does the guaranteed illustration show if the non-guaranteed elements perform poorly? The guaranteed vs non-guaranteed values in a policy illustration guide explains why the guaranteed column matters.

Say no if the benefits of the new contract rest on projected, non-guaranteed values, and you cannot see what happens at the guaranteed level.

Check 4: What happens to your contestability and suicide clocks?

Why it matters. A new life policy generally restarts the incontestability clause period, commonly two years in most states, during which the insurer can investigate a claim and rescind for a material misstatement on the application. The suicide clause period commonly restarts too. An old policy is past both. A death in the first two years of the new policy gets a closer look at the application, and any answer on it that was wrong, even innocently, becomes a risk.

Ask. Will the new policy start new contestability and suicide periods? If you die in year one, what will the insurer check? See replacing a policy resets the contestability clock: what to expect for how a review works.

Say no if you have any health history you are uncertain how to describe, or any chance the application will be incomplete, and the old policy is well past its contestability period.

Check 5: Has your health changed since the old policy was issued?

Why it matters. The new contract needs underwriting. If your health is worse than when you bought the old policy, you may be rated worse, charged more, or declined. You may also be insurable only for a lower amount. Giving up an approved policy for one you might not qualify for is the largest risk in a replacement. The 1035 exchanges: swapping policies without tax guide stresses not cancelling the old policy until the new one is issued and in force.

Ask. Have I been diagnosed with or treated for anything since the old policy was issued? Have I taken up or stopped a risk, such as tobacco use?

Say no if your health has worsened, unless the new contract is a product that does not depend on health, such as an annuity. Even then, the old policy's coverage is something you give up.

Check 6: Which guarantees would you give up?

Why it matters. Older policies sometimes carry features that are hard or impossible to buy today, and the new contract may not replicate them. Examples to look for are a no-lapse guarantees on universal life: how they work, a guaranteed minimum interest rate in a universal life policy, a fixed loan interest rate or loan structure, a favorable dividend history, a long-ago guaranteed insurability option, or a waiver of premium rider. Read your own contract to find which apply, rather than assuming.

Ask. What does the old contract guarantee that the new one does not? Which guarantee would I regret losing in 20 years?

Say no if the old contract has a guarantee that protects you against the very risk the new contract's projections ask you to take.

Check 7: Is the old policy's value really being compared like for like?

Why it matters. Replacement sales often compare an old contract's current performance with a new contract's projected performance. The old one is real; the new one is an illustration. The comparison should use the same assumptions on both sides, and the old policy's in-force illustration should be requested from the old insurer, not supplied by the agent selling the new one. See how to request and read an in-force illustration and the policy illustration entry.

Ask. Do I have an in-force illustration from the old insurer, dated this month? Does the new illustration use a stated rate, and what happens at a rate lower than the one shown?

Say no if the comparison was produced entirely by the party who earns the commission and you have no independent copy of the old policy's numbers.

Check 8: What happens to the loan?

Why it matters. A loan on the old policy that is not carried over is generally treated as cash received, and the tax-free exchange can produce a taxable gain, sometimes with no cash to pay it. A new policy that carries the loan has its own lapse risk. The policy loan entry has the basics, and the companion post exchanging a policy that carries a loan and where the tax bill hides works through the arithmetic.

Ask. Is there a loan? Will it be paid off or carried over? What does the old insurer's pre-exchange statement show as gross value, loan, and net amount?

Say no if the loan is large compared to your basis and nobody has shown you the tax result in numbers.

Check 9: Does the new policy pass the modified endowment test?

Why it matters. A large transfer into a new life policy is tested against the seven-pay limit. A policy that fails is a modified endowment contracts and the 7-pay test, with loans and withdrawals taxed gain-first and a 10% additional tax before age 59½ on the taxable part. That could undo the reason for owning a cash value policy.

Ask. Will the new policy be a modified endowment contract? Is the old one? Can the insurer state this in writing?

Say no if the plan depends on later tax-favored loans and the new policy could be a modified endowment contract.

Check 10: Who gains from the exchange, and by how much?

Why it matters. A replacement often pays the person selling it a new commission, while advice to keep what you have pays nothing. That does not make an agent dishonest, and many replacements are sensible. It does mean that the person arguing for the change has a financial stake you should name. Regulators watch for the practice of pushing needless replacements, known as twisting or churning; see twisting and churning: replacement sales abuses. State rules require disclosure forms and notices for replacements, and your state insurance department takes complaints.

Ask. How is the person advising me paid on the new contract compared with doing nothing? Would I get the same recommendation from a fee-only adviser who is paid by me, not by the sale?

Say no if the advisor will not explain their compensation, or pushes you to act quickly. A real replacement can wait a week for you to review it.

Putting the ten answers together

Here is a way to summarize what you found. Count the number of "say no" flags in the list.

This is a rule of thumb, not a formula. One serious flag, such as worsened health or a large taxable loan, can outweigh nine clean checks.

A hypothetical example of the checklist at work

The following is hypothetical. Say Greg, 63, owns a universal life policy he bought at 45. An agent proposes an exchange into a newer policy with a lower stated premium.

• Check 1: The reason is lower premiums. Greg could also reduce the face amount, so the problem might have another solution.
• Check 2: The surrender charge ended years ago, so there is no penalty. Clean.
• Check 3: The new policy has a 10-year surrender schedule. A flag.
• Check 4: The new policy restarts contestability. Greg has a heart condition he disclosed on the first application; he is not sure how to answer the new questions. A flag.
• Check 5: His health has worsened, so the new policy may be rated. A flag.
• Check 6: His old policy has a no-lapse guarantee that the new one lacks. A flag.
• Checks 7 to 10: no illustration from the old insurer, no loan, not a modified endowment contract, and the agent will be paid a first-year commission. Two flags.

With six flags and a new contract that depends on projections, Greg should lean toward keeping the old policy, perhaps lowering the death benefit. The keep, surrender or sell your policy? can compare the alternatives. This is an illustration of how to read a checklist, not a recommendation for anyone's real situation.

What to do instead of an exchange

If the checks point away from a replacement, the problem you named may still need a fix.

• Premium too high: ask about lowering the death benefit, a reduced paid-up option or another nonforfeiture option, or paying a different mode.
• Policy no longer needed: compare surrender, a life settlement and keeping it, with the tax effects explained in surrender or sell a policy, and how each exit is taxed in principle.
• Cost concerns: ask the insurer for an in-force illustration and a statement of charges.
• Need for income or care coverage: an exchange into an annuity or a long-term care contract may genuinely be the right tool, but run the same ten checks on that contract.

Key takeaways

• Tax-free does not mean cost-free: an exchange can trigger a surrender charge on the old policy and start a new schedule and commission on the new one.
• A new life policy generally restarts the contestability and suicide clauses, and worse health can mean a higher rating or a decline, so keep the old policy until the new one is in force.
• Compare guarantees and use the old insurer's own in-force illustration, not one prepared only by the seller of the new contract.
• Loans and modified endowment status can turn a deferred gain into a taxable one; get both answers in writing.
• Ask how the adviser is paid, and take the time to get a second opinion before you apply.