What Is a 1035 Exchange? Definition and How the Rules Work

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 one of like kind.

To qualify for an exchange, the contract or policy owner must also meet certain other requirements. 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

As noted above, a 1035 exchange allows individuals to transfer certain products like life insurance, annuities, and endowments to a similar vehicle on a tax-free basis. This means that these transfers must occur generally between products of like kind, such as life insurance for life insurance or a non-qualified annuity for a non-qualified annuity.

There are a few small exceptions. A life insurance policy can be exchanged for a non-qualified annuity, but a non-qualified annuity cannot be exchanged for a life insurance policy. The 2006 Pension Protection Act (PPA) also modified IRC section 1035 to include exchanges from life insurance policies and non-qualified annuities into traditional and hybrid (life insurance or annuity) qualified long-term care products.

Under a 1035 exchange, the contract or policy owner cannot take constructive receipt of the funds and then use them to buy a new policy. The money must be transferred directly. The rules also state that the annuitant or policyholder must also remain the same. For example, a 1035 exchange from an annuity owned by Joe Sample cannot be exchanged into an annuity owned by Jane Sample or into a joint annuity owned by Joe and Jane Sample.

Although the transfer isn't taxable, it is reportable. This means that the exchange must be reported on the individual's annual tax return using Form 1099-R.

Special Considerations

Before requesting a 1035 exchange, it is important to compare the features of each policy or contract subject to the exchange and conduct a cost-benefit analysis to determine which is best. Consider whether the new policy aligns with your investment goals. Similarly, consider how well the new product helps you reach your retirement goals if you're considering a transfer between retirement products.

Pay attention to administrative fees and transaction charges, such as withdrawal or surrender charges. If your existing product is no longer subject to withdrawal charges yet the new one is, consider how this will affect when you can access your money and how much it will cost to do so. Be sure to also review other factors, such as any associated mortality risk, administrative charges, and investment fees.

If the product delivers upon your goals and objectives, make sure that the new financial institution is sound. Review its financial ratings, financial statements, and other metrics to see how well it manages its assets, liabilities, and shareholder obligations if any.

Benefits of a 1035 Exchange

The primary benefit of a Section 1035 exchange is that it lets the contract or policy owner trade one product for another with no tax consequences. That way, they can exchange outdated and underperforming products for 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, if the owner exchanges one product for another within the same company, the fees may be waived.

Example of a 1035 Exchange

Here's a hypothetical example to show how a 1035 exchange works. Let's say Joe Sample invested a total of $100,000 (the cost basis) in a non-qualified annuity. During the course of the investment, 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 decided to transfer 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.