Will a 1035 exchange with a life insurance policy that has a loan balance trigger a tax?

Question

Does this always happen? Is there a way out of this?

Answer 1

1035 refers to a provision in the tax code which allows for the direct transfer of accumulated funds in a life insurance policy, endowment policy or annuity policy to another life insurance policy, endowment policy or annuity policy, without creating a taxable event

Even surrendering the policy will only create a taxable event if the surrender value is greater than the premiums paid.

Answer 2

If the loan is rolled with the 1035, it will not trigger recognition of income.  If the loan is smaller than your cost basis and is not rolled with the 1035, it will not trigger recognition of income.  

You will only recognize income from the loan in a 1035 if the loan amount that you do not roll over is more than your cost basis (what you put in).  If your insurance broker is any good, they should be able to talk with you about alternatives.

In more normal terms, if you don't move the loan over to the new policy, the old company let's you keep the money and is no longer a loan they expect to get paid back.  What used to be a loan is now income, and your income is more than you paid in, you owe tax.