What Is a 1035 Exchange Definition and How the Rules Work

A 1035 exchange is a provision in the IRS code that allows for a tax-free transfer of an existing annuity contract, life insurance policy, long-term care product, or endowment for another one of the same kind. The contract or policy owner must also meet certain requirements to qualify for an exchange. Different companies may have varying rules, but both full and partial 1035 exchanges are generally allowed. Exchanges between products within the same company are typically not reportable for tax purposes, as long as the exchange criteria are satisfied.

Section 1035 of the tax code permits tax-free exchanges of certain insurance products. Life insurance policyholders can use a 1035 exchange to trade their old policy for a new one with improved features. The 2006 Pension Protection Act modified the law to allow exchanges into long-term care products. However, an annuity cannot be exchanged for a life insurance policy under the Internal Revenue Code 1035. In a full exchange, the cost basis of the former policy becomes the basis of the new one.

A 1035 exchange allows individuals to transfer products such as life insurance, annuities, and endowments to a similar vehicle on a tax-free basis. The transfer must generally occur between like-kind products. There are exceptions—while a life insurance policy can be exchanged for a non-qualified annuity, the reverse is not allowed. The transfer must also be made directly, with no constructive receipt of funds. Additionally, the annuitant or policyholder must remain the same throughout the exchange.

Although a 1035 exchange is not taxable, it is reportable and must be reported on an individual’s tax return using Form 1099-R. The term "1035 exchange" refers to exchanges between insurance policies, annuities, and endowments outlined in Section 1035 of the Internal Revenue Code.

Before requesting a 1035 exchange, it is important to compare the features of each policy or contract and conduct a cost-benefit analysis. Consider whether the new policy aligns with your investment goals and helps you reach your retirement objectives. Pay attention to administrative fees, transaction charges, and other factors such as mortality risk, administrative charges, and investment fees. Additionally, review the financial stability of the new financial institution.

A significant benefit of a 1035 exchange is the ability to trade one product for another with no tax consequences. This allows individuals to exchange outdated or underperforming products for new ones with better features. However, obligations under the original contract, such as surrender charges, are typically not waived. Partial exchanges allocate a portion of the cost basis to the new product.

To illustrate how a 1035 exchange works, let’s consider an example: Joe Sample invested $100,000 in a non-qualified annuity, which later decreased in value to $75,000. Dissatisfied, Joe decided to transfer the funds to another annuity with a different company. Despite only transferring $75,000, the cost basis of the original contract ($100,000) becomes the basis of the new one.

Not all transfers qualify as 1035 exchanges. Transfers between qualified accounts, such as IRAs and 401(k)s, are not considered 1035 exchanges. The IRS disallows certain transfers, such as annuity to life insurance, endowment to life insurance, and annuity to endowment.

A 1035 exchange must be reported on a tax return. If the funds are transferred from one institution to another, a 1099-R form with a distribution code of 6 (indicating a 1035 exchange) is issued. Although the exchange is reportable, it is not taxable. In-house exchanges may not require a 1099-R form.

While a 1035 exchange can be characterized as a replacement, not every replacement qualifies as a 1035 exchange. An exchange of an annuity or life insurance policy for another annuity is both a replacement and a 1035 exchange. However, an exchange of an annuity contract for a life insurance policy is a replacement but does not qualify as a 1035 exchange.

In conclusion, a 1035 exchange allows for the non-taxable transfer of certain insurance products. It offers policyholders the opportunity to exchange one product for another without facing tax consequences. However, careful consideration must be given to the costs, fees, and alignment with goals and objectives. Policyholders should thoroughly evaluate their options before proceeding with a 1035 exchange.