A 1035 exchange is a provision in the Internal Revenue Service (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 of a 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.
Key Takeaways
- Section 1035 of the tax code allows for tax-free exchanges of certain insurance products.
- Life insurance policyholders can use a section 1035 exchange to trade an old policy for a new one with better features.
- The 2006 Pension Protection Act modified the law to allow exchanges into long-term care products.
- A life insurance policy can be exchanged for an annuity, yet an annuity cannot be exchanged for a life insurance policy under IRC 1035.
- The cost basis of the former policy becomes the basis of the new one for full exchanges.
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 generally occur 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 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’s 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 while 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.
The new product for which a modified endowment contract (MEC) was exchanged will also be an MEC. The 1035 exchange does not change that status.
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. This 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 from 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.
The tax treatment differs for partial exchanges in that a portion of the cost basis is allocated to the new product rather than all of it.
Example of a 1035 Exchange
Here’s a hypothetical example to illustrate 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.
What Is Not Allowed in a 1035 Exchange?
Transfers between qualified accounts, such as IRAs and 401(k)s, are not characterized as 1035 exchanges. The IRS allows exchanges of like-kind insurance policies, such as deferred annuities and life insurance policies, without triggering a taxable event. Permissible transactions include insurance policies exchanged into annuities, annuities into annuities, and endowments into endowments. The IRS disallows the following under a 1035 exchange:
- Transfer of funds from the account holder to the institution (must be directly transferred from the financial institution)
- Exchanges between like-kind accounts where the annuitant or owner on the existing account is not the same on the new account
- Annuity to life insurance
- Endowment to life insurance
- Annuity to endowment
Do I Have to Report a 1035 Exchange on My Tax Return?
A 1035 exchange must be reported on a tax return. If the funds are transferred from institution to institution, the transferring company will issue a 1099-R form, recording the amount transferred and a distribution code of “6” which denotes a 1035 exchange. Although the transaction is reportable, it is not taxable. If the exchange occurs in-house, the financial institution may not issue a 1099-R.
What Is the Difference Between a Replacement and a 1035 Exchange?
A 1035 exchange can be characterized as a replacement; however, not every replacement qualifies as a 1035 exchange. For example, when an annuity or life insurance policy is exchanged into another annuity, it is a replacement and a 1035 exchange. An exchange of an annuity contract for a life insurance policy can be characterized as a replacement but does not qualify as a 1035 exchange. Such transactions are taxable, with gains and losses recognized.
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.
Related Terms: Internal Revenue Code, Pension Protection Act, non-qualified annuity, financial institution, cost-benefit analysis.
References
- Internal Revenue Service. “Instructions for Forms 1099-R and 5498: Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc.”, Page 2.
- Code of Federal Regulations. “26 CFR 1.1035-1 - Certain Exchanges of Insurance Policies”, Page 143.
- U.S. Congress, The Joint Committee on Taxation. “Technical Explanation of H.R. 4, the ‘Pension Protection Act of 2006,’ as Passed by the House on July 28, 2006, and as Considered by the Senate on August 3, 2006”, Pages 194-195. Download PDF.
- Internal Revenue Service. “26 CFR: 1.1035-1: Certain Exchanges of Insurance Policies: Rev. Rul. 2007-24”.
- Cornell Law School, Legal Information Institute. “26 U.S. Code § 1035 - Certain Exchanges of Insurance Policies”.
- U.S. Code. “26 USC 7702A: Modified Endowment Contract Defined”.
- Internal Revenue Service. “26 CFR 1.1035-1: Certain Exchanges of Insurance Policies; Notice 2003-51”, Page 2-3.
- Code of Federal Regulations. “26 CFR 1.1035-1 - Certain Exchanges of Insurance Policies”.
- Internal Revenue Service. “Instructions for Forms 1099-R and 5498: Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc.”, Pages 2, 15.
