What is a 1035 exchange?

The Internal Revenue Service (IRS) law has a provision known as a 1035 exchange that permits the tax-free transfer of an existing life insurance policy, endowment, long-term care product, or annuity contract for another one of a similar sort.

The contract or insurance owner must fulfill other conditions to be eligible for an exchange. Firm policies may differ, although whole and partial 1035 swaps are permitted. For tax reasons, 1035 exchanges between goods sold by the same company are frequently exempt from reporting requirements.

How a 1035 Exchange Works

As mentioned, a 1035 exchange enables people to move certain products—such as endowments, annuities, and life insurance—to a tax-free comparable vehicle. Accordingly, these transfers must often occur between similar products, such as life insurance and non-qualified annuities or life insurance and life insurance.

A few minor exclusions exist. One cannot swap a non-qualified annuity for a life insurance policy, but one may exchange a life insurance policy for a non-qualified annuity.

The 2006 Pension Protection Act (PPA), which amended IRC Section 1035, also made it possible to exchange non-qualified annuities and life insurance policies for conventional and hybrid (annuity or life insurance) qualifying long-term care products.

The contract or policy owner cannot accept constructive receipt of the money under a 1035 exchange and use it to purchase a new policy. Direct money transfers are required.

The policyholder or annuitant must keep the same according to the requirements. For instance, a 1035 exchange from a Joe Sample annuity cannot be converted into a combined Joe and Jane Sample annuity or a Jane Sample annuity.

The transfer is reportable even if it isn’t taxable. This implies that Form 1099-R must be used to disclose the transaction on the taxpayer’s yearly tax return.

The term “1035 exchange” refers to exchanges between comparable goods, such as insurance policies, annuities, and endowments, as described in Section 1035 of the Internal Revenue Code (IRC).

Particular Points to Remember

Before seeking one, weighing the advantages and disadvantages of any insurance or contract that is the topic of a 1035 exchange is crucial. This will allow you to make an informed decision. Examine if the new policy is in line with your financial objectives. Similarly, when considering switching retirement products, consider how effectively the new product helps you achieve your retirement objectives.

Watch for transaction fees and administrative costs, such as withdrawals or surrenders. If withdrawal fees are associated with the new product but not the previous one, consider how this will impact when and how much you may access your money. Ensure you closely examine other aspects, such as investing fees, administrative costs, and any related mortality risk.

If the product meets your needs and expectations, confirm the stability of the new financial institution. Assess the company’s ability to manage its assets, liabilities, and any outstanding shareholder commitments by looking at its financial ratings, financial statements, and other measures.

A modified endowment contract (MEC) will also be exchanged for the new product. The status remains unchanged by the 1035 exchange.

Advantages of 1035 Exchange

A Section 1035 exchange’s main advantage is allowing the contract or policy owner to switch out one product for another without incurring any tax penalties. In this manner, they may swap out old, ineffective goods for newer models with more alluring features, such as more excellent investing alternatives and fewer constrictive clauses.

One thousand thirty-five swaps do not release contract owners from their responsibilities under the original contract, even with the tax advantages. For instance, insurance carriers often do not waive surrender fees for 1035 swaps. However, if the owner substitutes one product for another one that the same company offers, the costs might disappear.

Partial exchanges have a different tax treatment because a portion of the cost basis is applied to the new product rather than the whole amount.

7 Illustrations of a 1035 Exchange

Here’s a fictional scenario to demonstrate the operation of a 1035 exchange. Assume Joe Sample purchased a non-qualified annuity for $100,000 (the cost basis). Joe did not take out any loans or withdrawals over the investing period. Thus, the value has not changed.

Due to subpar investment results, the annuity’s value decreased to $75,000. Since he was unhappy, Joe moved his money into a different annuity with a different business. In this case, the $100,000 cost basis of the first contract remains the foundation of the new contract, even if only $75,000 was transferred.

What is a 1035 exchange that is not permitted?

One thousand thirty-five exchanges do not apply to transfers between qualifying accounts, such as 401(k)s and IRAs. The IRS permits exchanges of like-kind insurance policies, such as life insurance policies and deferred annuities, without creating a taxable event. Exchanges of insurance policies for annuities, annuities for annuities, and endowments for endowments are examples of these acceptable transactions. The IRS prohibits the following under a 1035 exchange:

Money transfer from the account holder to the financial institution (must come from the financial institution directly)

exchanges between like-kind accounts where the new account’s owner or annuitant differs from the previous account’s

• Life insurance annuity
• Life insurance endowment
• Retirement and endowment

Does a 1035 exchange need to be reported on my tax return?

A tax return is required to disclose a 1035 exchange. The transferring firm will send a 1099-R form documenting the amount transferred and a distribution code of 6″ that indicates a 1035 exchange if the money is moved between institutions. The transaction is not taxable, even though it must be reported. The financial institution may not issue a 1099-R if the transaction occurs internally.

What distinguishes a 1035 exchange from a replacement?

You may think of a 1035 exchange as a replacement, but not all replacements are 1035 exchanges. An example of a replacement or 1035 exchange is the exchange of a life insurance policy or an annuity for another annuity. Although it is not a 1035 exchange, exchanging an annuity contract for a life insurance policy might be considered a replacement. Gains and losses on these transactions are recorded and are subject to taxes.

The Final Word

Specific insurance policies may be exchanged for non-taxable benefits under Internal Revenue Code Section 1035. Exchanges between an annuity and a life insurance policy, an endowment and another, and a life insurance policy and another are all permitted. Notwithstanding losses that have reduced the balance, the cost basis of the previous policy or contract serves as the foundation for the current one. When switching from one plan to another, policyholders should proceed with prudence, mindful of lost benefits, costs, and alignment with objectives.

Conclusion

• Certain insurance products may be exchanged for tax-free products under Section 1035 of the tax law.
• Policyholders for life insurance may swap an outdated policy for a more feature-rich one via a Section 1035 exchange.
• The Pension Protection Act of 2006 changed the law to allow for exchanges of long-term care products.
• Under Internal Revenue Code 1035, an annuity cannot be exchanged for a life insurance policy, but a life insurance policy may be exchanged for an annuity.
• The new policy’s cost basis for complete exchanges replaces the previous one.