1035 Exchanges: The Best-Kept Secret for Tax-Free Long-Term Care Planning
Long-term care (LTC) planning is one of the biggest challenges facing financial professionals today. With the cost of care skyrocketing and traditional LTC insurance becoming less accessible, advisors need every tool in their arsenal to help clients secure affordable, tax-efficient coverage. Enter the 1035 exchange—a little-known but highly effective strategy that can convert outdated life insurance policies into powerful long-term care solutions.
Yet, despite its clear benefits, 1035 exchanges remain vastly underutilized. Why? Many financial professionals either don’t fully understand the rules or fail to recognize the game-changing potential these exchanges offer their clients. Let’s break it down.
What is a 1035 Exchange, and Why Should Advisors Care?
Section 1035 of the Internal Revenue Code allows policyholders to exchange an existing life insurance policy or annuity for another without triggering immediate tax consequences. The Pension Protection Act of 2006 expanded the scope of 1035 exchanges to include policies with LTC benefits, meaning clients can now reposition their cash value policies into hybrid life-LTC or annuity-LTC products—completely tax-free.
Key Benefits of Using 1035 Exchanges for LTC Planning
1. Tax-Free Transfers = Major Savings
Without a 1035 exchange, cashing out a life insurance or annuity policy could result in significant taxable gains. By utilizing a 1035 exchange, clients avoid these taxes while repositioning their assets into policies that provide LTC coverage.
2. Turning Dead Money into Living Benefits
Many clients own outdated life insurance policies with low death benefits or underperforming annuities they no longer need. Rather than letting these assets sit idle, a 1035 exchange allows them to be repurposed into policies that provide critical LTC coverage—benefits they’re far more likely to use.
3. Guaranteed Premiums, No Rate Hikes
One of the biggest pitfalls of traditional LTC insurance is the potential for future rate increases. Hybrid life-LTC policies, which are eligible for 1035 exchanges, often feature guaranteed premiums, providing clients with cost certainty.
4. LTC Benefits or Death Benefit—No Loss of Value
With hybrid life-LTC products, if the insured never needs long-term care, their beneficiaries still receive a tax-free death benefit. This eliminates the “use it or lose it” concern that deters many clients from purchasing traditional LTC insurance.
How to Identify the Right Clients for a 1035 Exchange
Not every client is a candidate for a 1035 exchange, but many will be. Here’s how to identify the best prospects:
Clients with old cash value life insurance policies they no longer need for income replacement.
Policyholders concerned about rising LTC costs who lack dedicated coverage.
Individuals with non-qualified annuities who want to reposition assets for tax-free LTC benefits.
Clients hesitant to buy standalone LTC insurance due to premium hikes or the risk of not using the benefits.
Case Studies: Real-World Applications of 1035 Exchanges for LTC
Case Study #1: Repurposing an Unused Life Insurance Policy
A 68-year-old client had a $200,000 universal life policy with $80,000 in cash value. The policy was no longer needed for estate planning, and the client was concerned about potential LTC expenses.
Solution: A 1035 exchange into a hybrid life-LTC policy provided $6,000/month in LTC benefits for up to six years. If care was never needed, the policy would still provide a $220,000 tax-free death benefit to heirs.
Case Study #2: Maximizing an Existing Annuity for LTC Benefits
A 72-year-old couple had a $250,000 non-qualified annuity that was underperforming and generating unnecessary taxable gains. They were also concerned about future healthcare expenses.
Solution: A 1035 exchange into a linked-benefit annuity provided both spouses with $500,000 in total LTC benefits, while keeping the annuity principal intact if LTC was never needed.
Common Pitfalls and How to Avoid Them
While 1035 exchanges offer incredible advantages, they require careful execution. Here are some common mistakes and how to prevent them:
Not Checking Underwriting Requirements – Unlike a direct policy conversion, 1035 exchanges into hybrid LTC policies may require medical underwriting. Work with carriers to determine eligibility before proceeding.
Ignoring Surrender Charges – Some policies have surrender charges that could negate the benefits of an exchange. Always analyze costs before making a move.
Selecting the Wrong Replacement Policy – Not all hybrid LTC products are created equal. Ensure the new policy aligns with the client’s financial goals and care preferences.
The Bottom Line: A Must-Use Strategy for Financial Professionals
1035 exchanges for LTC planning are an underused but incredibly powerful tool that financial professionals should be leveraging more. They allow clients to convert existing policies into valuable long-term care coverage, all while maintaining tax efficiency and asset protection.
As the long-term care crisis intensifies, it’s time for advisors to step up and educate clients on this strategy. Don’t let outdated policies sit idle—turn them into a tax-free LTC solution that provides peace of mind and financial security.
Are you using 1035 exchanges in your LTC planning? If not, now is the time to start.
