A 1035 exchange is a way to trade an existing annuity or insurance policy for a new one without paying taxes. You’re ultimately “exchanging” one product for another product with better benefits, and the new policy must be of equal or greater value. It’s somewhat similar to rolling money over from one retirement plan to another. You still report the transaction via a 1099-R, but you don’t have to pay taxes as long as you meet the requirements of Section 1035 of the Internal Revenue Code

There are several factors you should consider when deciding whether to use a 1035 exchange.

When to use a 1035 exchange

With the stock market and interest rate conditions continuously changing, a once-perfect investment may no longer be a good fit. Is it time to trade in that investment? Possibly. Consider the following questions first.

  • Are you getting a better rate or lower costs? 
  • Has your original investment’s value dropped?
  • Did you inherit an annuity? 
  • Is there a greater death benefit? 
  • Will this change provide you with a broader selection of investment choices? 

These are only a few of the questions you should be asking yourself and discussing with a financial advisor. If there is no gain for the policyholder, it may not be advantageous to complete a 1035 exchange. Still, it is certainly a solution worth exploring.

What’s allowed in a 1035 exchange?

Understanding a 1035 exchange and the options that go along with it is key to deciding whether it makes sense for your portfolio. Let’s start with a fundamental review of which investments qualify for a 1035.

Life insurance

Life insurance comes in many forms: term life insurance, variable life insurance, whole life insurance, and universal life insurance. All are eligible for a 1035 exchange. 

Say your intended beneficiary passes away before you. Rather than cashing out your life insurance policy and paying taxes, you can look at transferring it into an annuity or exchanging it to purchase long-term care insurance.

Annuities

Maybe you initially invested in a variable annuity, but it’s not performing well. Or perhaps you want to move your investment to a fixed deferred annuity or a fixed indexed annuity. With a 1035 exchange, you’re able to adjust your investment strategy, so your money is in better performing annuities. 

Inherited annuities 

If you’ve inherited an annuity, but have no interest in keeping it, you have options outside of cashing it out. The IRS allows you, as the beneficiary, to exchange inherited annuities for another annuity product that more accurately reflects your investment goals.

Long term care insurance

The Pension Protection Act of 2006 expanded 1035 exchanges to include qualified long-term care insurance, which began in 2010. Long-term care insurance, of course, pays for an array of services that aren’t covered by health insurance. Think nursing homes or paying for in-home senior care. Those types of expenses can add up quickly and may deplete your retirement savings. Meaning long-term care insurance may be a smart investment, and a 1035 exchange can be an easy way to make it happen.

Any policyholders who have a life insurance policy they may no longer need or have a non-qualified annuity with a significant tax-free build-up may benefit from an exchange to purchase long-term care insurance. Just be sure to research long-term care insurance providers as not all agencies accept a 1035 exchange.

Endowments

Endowments are often organized as a trust, foundation, or non-profit. And they almost always have guiding documents that dictate how they are managed. Using them as part of a 1035 exchange can be tricky, but it is possible. While they cannot purchase life insurance, they can be used for other like-kind exchanges.

What are “like-kind” exchanges?

A 1035 exchange doesn’t have to be an actual trade. You can complete what’s called a like-kind exchange where you have numerous options for investment. 

Acceptable forms of like-kind exchanges include:

  • Life insurance for life insurance
  • Life insurance for endowment
  • Life insurance for non-qualified annuity
  • Endowment for endowment, with a maturity not later than the original endowment
  • Endowment for non-qualified annuity
  • Non-qualified annuity for non-qualified annuity

What not to do in a 1035 exchange

Before you choose to move forward, it’s important to note some limitations of a 1035 exchange. There are a few things you cannot do, and that includes: 

Add or remove policyholder

The policyholder must remain the same. You cannot add a spouse or replace the account owner when doing a 1035 exchange.

Cash-out an account

Suppose an owner cashes out of a current contract and immediately applies the proceeds to a new contract. In that case, it will not be treated as a tax-free event. Be sure your agreement goes directly from one insurance company to another if you want to qualify for a 1035 exchange and avoid paying taxes.

Surrender fees explained

Most annuities and investments have a surrender charge, which is a penalty for making an early withdrawal above the free withdrawal amount. This charge is used to pay your financial professional a commission. It’s typically a percentage of the amount withdrawn. 

Because you’re not withdrawing money in a 1035 exchange, you may think you’re safe from surrender fees. But, that may not be the case. 

According to the Securities and Exchange Commission (SEC), an annuity contract that is still in the surrender charge period, may mean you’re required to pay the surrender charge when undertaking a 1035 exchange. Similarly, your new annuity contract may be subject to its own surrender charge period. This timeline could be longer than the remaining period on the old contract. 

If this applies to you, be sure you understand the charges and carefully consider whether you need the benefit.

Is a partial transfer a better solution?

Is your annuity still subject to a surrender charge? You may be able to avoid that fee and make a change to your investment strategy. Partial exchanges are another way to diversify your holdings. A partial exchange means only a portion of your existing investment is paid, or exchanged, to acquire the new investment. This may be done by assigning a part of the contract’s account value to a new annuity contract. The remaining portion is then retained in the “old” agreement.

To qualify as a tax-free partial 1035 exchange, you cannot take a distribution from either contract within 180 days of the exchange*. If you do, the IRS may treat the delivery as part of the original transaction, which causes the full amount of income (from both contracts) to be taxable. It may also result in higher taxes, penalties, and fees.

*An exception to the 180-day rule is if the distribution is received as an annuity for life or a period of 10 years or more.

Tax reporting

As mentioned earlier, a 1035 exchange is not a taxable event. However, you do have to notify the IRS. You’ll receive a 1099-R to report the transaction made to another insurance company.* Be sure to verify the form’s information and include it on your tax return.

Despite the potentially favorable tax treatment, you should exercise caution when entering into a 1035 exchange.  Any cash received, amounts transferred into a non-qualifying contract, or amounts used to pay off an outstanding loan on the original contract will be taxed as income tax. This is especially important to pay attention to when you choose a partial 1035 exchange.

Be sure to speak with a tax professional to understand how you may be affected.

*The reporting requirement may be waived if the same company issues both annuities or insurance policies.

Speak with a financial advisor

All 1035 exchanges, whether full or partial, require serious thought. So give one of our financial advisors a call today. We’re happy to further discuss 1035 exchanges, as well as other strategies that may strengthen your financial portfolio.