1035 exchange

All about 1035 exchanges

Life changes constantly. It may have changed drastically since you purchased an annuity or life insurance policy years ago. When your financial needs change, it may be time to exchange an insurance policy or annuity for a better option.

If you sell or surrender your current policy first, the transaction could result in a tax bill if there is a gain in the value of the contract from when it was purchased. But there is a way to update your annuity while deferring taxes on your current policy or contract. You can do so through a 1035 exchange.

A 1035 exchange is based on Section 1035 of the Internal Revenue Code that allows policyholders to exchange annuity contracts or life insurance policies without incurring a taxable event at the time of the transaction. You’re simply transferring the funds from one contract to another, similar to rolling over a 401(k) account into another 401(k) or IRA.

The insurance company from which you are buying the new contract will typically contact the company that issued your current policy — assuming they are different — and ask for the funds to be transferred. This process can take several months to complete.

If you want to purchase an annuity through a 1035 exchange, you can exchange a life insurance policy, an endowment insurance contract or an existing annuity.

The IRS also allows annuity holders to exchange a portion of the value in an existing annuity for a new annuity contract. You can also exchange multiple annuity contracts for a single contract.

1035 exchange considerations

A 1035 exchange is only allowed when it involves the same contract or policy holder. The cost basis of the original policy being exchanged will carry over into the new contract. For example, if you bought an annuity for $50,000 and it’s worth $75,000 when you exchange it, you will begin the new contract with a $25,000 gain.

Also keep in mind that, while you may not have a tax bill for a 1035 exchange, you may owe surrender penalties to the carrier that issued your current contract if the annuity has not reached the end of its surrender period. For example, if you exchange a 10-year annuity six years after you purchased it, the insurance company will deduct a surrender penalty for the remaining four years from the proceeds.

And while you can defer income taxes doing a 1035 exchange, you may incur a tax penalty. This could occur if you exchange a deferred annuity for an immediate annuity, and you have not reached age 59 1/2. The IRS would treat this as though you were beginning annuity withdrawals on a tax-deferred account before the allowable age of 59 1/2.

If you exchange a deferred annuity for an immediate annuity, you can avoid the tax penalty if at least one of the following is true:

  • Payments begin on or after the date you reach age 59 1/2
  • Payments are part of a series of substantially equal periodic payments made for the life expectancy of the taxpayer or the joint life expectancies of the owner and his or her beneficiary.

Reasons for exchanging a contract

There are a number of reasons why you would consider updating your annuity or exchanging a life insurance policy for an annuity via a 1035 exchange:

Changes in life circumstances. Any time you have a major life event, you should review your financial situation and your portfolio. If you determine that your current investments or policies don’t meet your needs, then a 1035 exchange might be useful.

For example, say you own a life insurance policy with your spouse as the beneficiary. Unfortunately, your spouse passes away and you have no other family members to designate as a beneficiary. But you could use a little extra lifetime income for retirement. You could 1035 exchange the life insurance policy and its cash surrender value could then buy an immediate annuity.

Your current annuity is past its surrender period and you want to upgrade. Insurance companies are constantly changing rates and adding features on their annuity products. You could exchange your current annuity for one with better rates, stronger guarantees or a higher payout.

You inherited an annuity. The IRS has updated its 1035 exchange rules to allow the beneficiary of an inherited annuity to exchange it for a new one, under certain conditions. To qualify under this IRS ruling, the following conditions must be met:

  • The new annuity contract must extend the original contract’s terms.
  • The beneficiary will become the new contract owner for purposes of ongoing taxation.
  • The new contract must remain an annuity contract.
  • The current annuity’s value must be transferred to the new annuity company in its entirety.