1035 Exchange: How To Exchange an Annuity or Life Insurance Policy Tax-Free
If you’re looking to update a cash-value life insurance policy or annuity, you may have heard of the 1035 exchange. This IRS provision allows you to exchange one policy for another without any tax consequences.
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But the process of completing a 1035 exchange involves jumping through a few hoops and submitting the right paperwork to the IRS. Here’s a look at how 1035 exchanges work, what’s involved in completing one, the pros and cons of using a 1035 exchange, and how to determine if it’s a good fit for you.
What Is a 1035 Exchange?
A 1035 exchange is a type of like-kind exchange that allows a tax-free exchange of a life insurance policy, annuity contract, long-term care product or endowment for another of a similar structure. This means that any gains or losses from the previous contract are not recognized by the IRS, and no taxes are assessed when moving the cash value of one contract to another.
A 1035 exchange is a useful financial planning tool to help individuals move from one insurance contract to another. If you have an existing annuity or cash-value life insurance contract that no longer fits your needs, you can exchange it for a better-suited policy without unnecessary taxes.
How Do 1035 Exchanges Work?
A 1035 exchange is the legal process for exchanging one insurance contract or endowment for another. The Internal Revenue Code (IRC section 1.1035-1) allows individuals to exchange one contract for another of a like kind. This means that a life insurance contract can be swapped for another life insurance contract, or an annuity contract can be traded for another annuity contract.
There is an exception for life insurance policies — they can be swapped for an endowment, annuity contract or long-term care policy. But a nonqualified annuity, for example, can only be exchanged for another nonqualified annuity or a long-term care policy. This gives life insurance contract holders more flexibility when choosing to exchange their policy.
When you perform a 1035 exchange, you must report the transaction using IRS Form 1099-R.
What Is Not Allowed in a 1035 Exchange
There are several things that are not allowed in a 1035 exchange, including:
Changing the primary insured person: For all 1035 exchanges, the insured must remain the same. This means you can’t change the primary insured person on any policy and retain tax-free status on your exchange. You also can’t simply cash out a life insurance policy to purchase another — it must be an even trade from one policy to another.
Exchanging an annuity for a life insurance policy: A 1035 exchange does not permit exchanging a nonqualified annuity for a life insurance policy, and doing this may result in paying taxes on gains within the annuity.
Taking receipt of funds: You can’t cash out an existing policy and deposit funds in your bank account if the funds are used to purchase another policy. The IRS does not allow you to take constructive receipt of the funds from your existing policy — otherwise, it may be a taxable event.
Pros and Cons of Using a 1035 Exchange
While a 1035 exchange gives you some flexibility in exchanging one insurance contract or endowment for another, it’s not always the best idea. Here are a few pros and cons of using a 1035 exchange:
Pros
Avoid taxes: The primary benefit of a 1035 exchange is saving on taxes when exchanging one policy for another.
Better contract terms: A 1035 exchange lets you get out of a contract into one with more favorable terms and possibly better investment options.
Additional coverage: If you need more coverage for any reason, a 1035 exchange lets you pick a policy that better fits your needs without paying additional taxes.
Change companies: A 1035 exchange lets you change insurers to one you prefer.
Cons
May pay surrender fees: Many insurance contracts and annuities come with surrender charges that you may still have to pay when exchanging your policy.
Commissions on new policy: You may end up paying commissions on a new policy, which can reduce your accumulated cash value.
Contestability period: If you’re exchanging a life insurance contract, the new policy may have a contestability period where the insurance company could be absolved from paying out in certain instances for the first few years of the policy.
May still owe tax: Depending on your policy, you may still be hit with a tax bill, such as paying taxes on outstanding loans from the old policy.
Higher premiums: If your health has declined, you may end up paying more for a policy than you previously had with the old contract.
Should You Do a 1035 Exchange?
A 1035 exchange can be a great way to help you update your insurance or annuity coverages without the penalty of paying taxes on gains within the previous policy. You can avoid losing money to additional taxes while picking a policy that better suits your needs.
But it’s important to consider your total financial picture when considering a 1035 exchange, and make sure you understand any possible consequences of giving up your old policy as well. Since this process can be complicated, it’s a good idea to work with a tax professional to make sure you complete the process according to IRS regulations.
FAQ
What qualifies for a 1035 exchange?
Cash-value life insurance policies, annuity contracts, endowments and long-term care policies qualify for a 1035 exchange. Exchanging one policy for another of a like kind within a 1035 exchange allows you to avoid paying taxes on any gains within the policy.
Is a 1035 exchange a rollover or transfer?
A 1035 exchange is considered a like-kind transfer of one policy to another. It's not a rollover, per se, but simply exchanging one contract for another of similar terms. The cash value and cost basis of your old policy are carried over into the new policy, avoiding any taxes on the surrendered policy.
Do I have to report a 1035 exchange?
Yes, you must report a 1035 exchange on IRS Form 1040, lines 4b and 5b. When you transfer your policy to another institution, the transferring party will typically issue a 1099-R with details of the transaction for you to report to the IRS.
What is the difference between a 1031 exchange and a 1035 exchange?
A 1031 exchange is a like-kind exchange of real estate, while a 1035 exchange is a like-kind transfer of an insurance contract or endowment.
This article originally appeared on GOBankingRates.com: 1035 Exchange: How To Exchange an Annuity or Life Insurance Policy Tax-Free
