What is a 1035 Exchange?

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DEFINITION
A 1035 exchange is the tax-free exchange of one type of annuity or life insurance contract for another, with the policyholder and insured remaining the same.

A 1035 exchange is the tax-free exchange of one type of annuity or life insurance contract for another with the policyholder and insured remaining the same. 

Learn more about this policy exchange, what the requirements are, and whether it would be beneficial for you. 

Definition and Example of a 1035 Exchange? 

A 1035 exchange is the tax-free exchange of one type of annuity, endowment, or life insurance contract for another. To meet the requirements for this law, you must be exchanging a policy for another of like-kind.

Here are some common types of exchanges that qualify: 

  • A life insurance policy to another life insurance policy 
  • A life insurance policy to an annuity 
  • An annuity to another annuity 
  • A long-term care insurance policy to another long-term care insurance policy
  • An annuity for a long-term care insurance policy 
  • A contract of endowment insurance for an annuity

For example, if you have an annuity with a lower interest rate you could use the 1035 exchange to change to an annuity with a higher rate. You could also swap out the cash value of an old life insurance policy for a reduced paid-up insurance policy. Then you wouldn’t have to continue paying premiums. 

However, not all types of exchanges qualify under Section 1035. The law says that you can’t switch from an annuity to a life insurance policy. To do that, you’d have to surrender your annuity, pay any capital gains taxes, and then purchase the new life insurance policy.

A 1035 exchange has strict rules, and there may be other tax implications. If you’re considering trading in one of your policies for another, it’s best to get advice from a qualified professional.

How a 1035 Exchange Works

A 1035 exchange is derived from section 1035 of the Internal Revenue Code. This provision allows policyholders to transfer their funds from one type of life insurance contract or annuity to another if certain conditions are met.

To qualify for a 1035 exchange, you must meet two main requirements. 

First, the contract that is being exchanged has to be of “like-kind” with the new one. In other words, the new policy cannot be significantly different from the old one in terms of its nature and character. This means the policyholder and the insured person's name must stay the same. You can’t use this process to transfer ownership of a policy. 

Second, the proceeds from the original policy have to go into a new one. You can’t use them as cash or premium payments for another type of policy.

You can’t use a 1035 exchange to exchange the cash value of a permanent life insurance policy for a term life insurance policy. You must stick to policies of like-kind. 

Let’s say you purchased a variable non-qualified annuity early in your career when you had a higher risk tolerance but now you are approaching retirement. You want to switch to a fixed annuity that can provide more reliable income.

With the help of your financial advisor, you fill out the required paperwork and use a 1035 exchange to swap your old annuity for a new one. If you have financial gains from this annuity, you can transfer them all into the new policy without paying capital gains taxes. 

Read the terms and conditions of your new policy carefully before making the switch. You may have a new contestability period or higher premiums. 

Pros and Cons of a 1035 Exchange

A 1035 exchange does offer tax advantages if you want to change policies, but there are some downsides to consider as well. 

Pros
  • Can switch your policy 

  • Tax-free exchange

  • You can switch to a different insurance company 

Cons
  • Doesn’t work well with loans

  • May need to pay a surrender fee

  • Potentially higher premiums 


Pros Explained

  • Can switch your policy: A life insurance policy you purchased when you were young may not be a great fit for you today. Over time, interest rates can change, new products can debut, and you might want to switch to a policy with better terms. 
  • Tax-free exchange: If your 1035 exchange qualifies, you won’t have to pay any taxes, even if you’ve had gains. 
  • You can switch to a different insurance company: If you have concerns about your insurer, you can use a 1035 exchange to get a policy with a different company. 

Cons Explained

  • Doesn’t work well with loans: If you have an existing loan on your insurance policy, a 1035 gets complicated. It’s better to pay back the loan before you make the exchange.
  • May need to pay a surrender fee: If you make the exchange too soon, you may need to pay surrender charges, which reduce proceeds. 
  • Potentially higher premiums: If you are exchanging a life insurance policy that you bought it when you were younger and healthier, you may have higher premiums. If your status has changed, it may be harder to get a policy with the same terms. Be prepared to pay more. 

Key Takeaways

  • A 1035 exchange allows you to swap one type of annuity or life insurance contract for another of like-kind.
  • Exchanging your contracts can be beneficial if you can get a higher death benefit, lower premiums, or better investment options with the new plan. 
  • Though making this change doesn’t cause a tax burden, there may be other implications for the policy owner to consider. This includes potentially increased premiums, surrender charges, and changes to the terms. 
  • Because of these unanticipated consequences, it’s best to consult with an experienced professional who is familiar with your situation before doing a 1035 exchange. 

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