What Is a 1035 Exchange?

What Is a 1035 Exchange?

A 1035 exchange is a provision in the Internal Revenue Service (IRS) code allowing for a tax-free transfer of an existing annuity contract, life insurance policy, long-term care product, or endowment for another of like kind.

Rules may vary by company, but full and partial 1035 exchanges are allowed. Typically, 1035 exchanges between products within the same company are not reportable for tax purposes as long as the exchange criteria are satisfied.

How a 1035 Exchange Works

A 1035 exchange allows individuals to transfer life insurance, annuities, and endowments to a similar vehicle tax-free. These transfers must be between similar products, such as life insurance for life insurance or a non-qualified annuity for a non-qualified annuity. The 2006 Pension Protection Act (PPA) modified IRC section 1035 to include exchanges from life insurance policies and non-qualified annuities into traditional and hybrid qualified long-term care products.

Under a 1035 exchange, the contract or policy owner cannot take the funds and buy a new policy. The money must be transferred directly. The annuitant or policyholder must also remain the same.

For example, a 1035 exchange from an annuity owned by Joe Sample cannot be exchanged for an annuity owned by Jane Sample or a joint annuity owned by Joe and Jane Sample. The exchange must be reported on the individual's annual tax return using Form 1099-R.

Costs and Benefits

The primary benefit of a Section 1035 exchange is that it lets the contract or policy owner trade one product for another without tax consequences. Outdated and underperforming products can be switched to newer products with more attractive features, such as better investment options and less restrictive provisions.

Despite the tax benefits, 1035 exchanges do not absolve contract owners of their obligations under the original contract. For example, insurance companies typically don't waive surrender charges for 1035 exchanges. However, fees may be waived if the owner exchanges one product for another within the same company.

Product owners should compare the features of each policy or contract subject to the exchange and conduct a cost-benefit analysis. The new policy should match an individual's investment goals. Owners should consider the administrative fees and transaction charges, such as withdrawal or surrender charges. The financial institution for the new policy must be assessed on how well it manages its assets, liabilities, and shareholder obligations, if any.

Example of a 1035 Exchange

Joe Sample invested $100,000 (the cost basis) in a non-qualified annuity. Joe took no loans or withdrawals, so the value remains unaffected. Because of poor investment performance, the value of the annuity dropped to $75,000.

Dissatisfied, Joe transfers his funds into another annuity with another company. In this scenario, the original contract's cost basis of $100,000 becomes the new contract's basis, although just $75,000 was transferred.

The Bottom Line

Section 1035 of the Internal Revenue Code allows for the non-taxable exchange of certain insurance products. Allowable exchanges include a life insurance policy to an annuity, an annuity to an annuity, an endowment to an endowment, and a life insurance policy to a life insurance policy. The cost basis of the old policy or contract becomes the basis of the new one, despite losses that have eroded the balance. Policyholders should exercise caution when exchanging one product for another, paying careful attention to forgone benefits, charges, fees, and alignment with goals and objectives.