What is a 1035 exchange on a life insurance policy?

What Is A 1035 Exchange? A 1035 exchange is a legal way to exchange one insurance policy, annuity, endowment or long-term care product of like kind without triggering tax on any investment gains associated with the original contract. The IRS allows these exchanges under Section 1035 of the Internal Revenue Code.

What Is the Purpose of a 1035 Exchange?

The primary purpose of the 1035 exchange, also known as a “Section 1035 exchange,” is to switch out old and outdated products for a new one. 1035 exchanges involve the replacement of life insurance policies or annuity contracts for a new one of like kind. These exchanges are usually tax-free. It’s essentially a replacement process. Not all replacement transactions, however, are tax-free. Other types of taxed replacements are available.

A 1035 exchange without tax costs can potentially help you secure better rates and more desirable features. You can even retain the value of an original investment by transferring funds, even if investment value is reduced.

What Qualifies as a 1035 Exchange?

To qualify as a 1035 exchange your product or policy transfer must be from the same or similar product to another. For example, switching from a life insurance policy to another life insurance policy, or changing from a life insurance policy to a non-qualified annuity.

Products must also remain in the same account or policyholder’s name through the exchange; you cannot add or remove owners from an account.

How Does 1035 Exchange Work?

A 1035 exchange may sound complicated, but it’s actually a simple way to make sure that you have the right annuity or life insurance product that fits your needs.

Essentially, if you have an annuity or life insurance policy you would replace either one with a new annuity contract or insurance policy, respectively. In the case of an annuity, the annuitant or person receiving payments from the annuity (which would be you) must remain the same. With a life insurance exchange, you would still be the covered person but you could change the beneficiary on the policy.

When you make the exchange, no taxes are incurred on any investment gains associated with swapping out one contract for another. But there are a couple of rules the IRS requires you to follow:

When a 1035 exchange involves life insurance, you must make an even trade in swapping out your old policy for a new one. You can’t cash out the old policy and use the money to buy a new one.
1035 exchanges can only go certain ways. For example, you can exchange life insurance for life insurance or life insurance for a non-qualified annuity. But you can’t exchange a non-qualified annuity for a life insurance policy. Also, life insurance policies and non-qualified annuities may be exchanged for traditional and hybrid qualified long-term care products.

If you were to surrender a life insurance policy without going through a 1035 exchange to replace it with a new policy or an annuity, any gains associated with your original contract would be considered ordinary income. This is something to keep in mind if you have a permanent life insurance policy that allows you to build cash value through investments.

It’s also important to remember that any other exchanges of life insurance, annuities or endowments that don’t fit the IRS rules above would not enjoy tax-advantaged status.

Benefits of Using a 1035 Exchange

The primary advantage of using a 1035 exchange to change your life insurance policy or annuity choices is to avoid triggering taxes on those transactions. There are different scenarios where exchanging policies or annuity contracts might make sense. For example, you may want to do a 1035 exchange if:

You need more life insurance coverage than you currently have
You want to change the type of life insurance policy you have
You’re looking for an annuity contract with lower fees
You want to restructure your annuity payments
You need a completely different type of annuity

As long as you’re exchanging contracts within the guidelines set by the IRS you wouldn’t have to worry about those events being taxable to you. You may, however, still have to pay a surrender charge to trade one annuity contract or life insurance policy for another.

Surrender charges are essentially a penalty for canceling your contract with the insurance company or annuity provider. These fees vary in terms of how much they are and when you’ll have to pay them. They can be charged as a flat fee or as a percentage of the amount paid into the contract.

It’s possible that your life insurance company or annuity provider may waive any surrender charges if you’re exchanging policies or contracts with the same company. But if you’re moving your policy or contract to a brand-new company, you may have to factor in the surrender cost as part of the process.

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Benefits of a 1035 Exchange

So, why would you want to do a 1035 exchange? Whether you’re changing companies for customer service reasons or you’re hoping for better perks with an upgraded plan, there are a handful of benefits to completing a 1035 exchange.

1: No Tax Cost

The benefits of this type of exchange start with the fact that there’s no tax responsibility for switching out a contract. Tax penalties can be heavy for consumers who pull funds out of an account early, or those who cash out completely.

This is because “surrendering” a tax policy usually means you must pay tax on any positive gains. Those funds are counted as income once they enter your possession. However, moving the funds from one account to another—without cashing any out—doesn’t qualify as income because you don’t receive the money directly.

2: Consistent Account Value

Plus, this type of exchange also allows you to keep your cost basis, the original investment value. That means if you take an account to a new company, the cash value could be less than the cost basis, but your account’s worth stays the same.

3: Partial Transfers

You can also complete a partial exchange that moves a fraction of the cost basis to a new contract, rather than the entirety of your existing policy. It’s one way to diversify your holdings without incurring additional tax costs.

What to Consider Before Making a 1035 Exchange

If you’ve held a contract or policy for a long time without checking the market for changes, it might be time to make an exchange. But there are a few factors to consider before making the move, such as:

Lower potential costs for life insurance due to improved health/mortality statistics in the general population
Solvency concerns with the original insurance company or agent
Available features or benefits of new policies
Potential for loss of death benefits
Cash value of the original policy, whether you’ll need to pay for a new policy due to overall cost
Potential for paying higher premiums if your health has declined or due to market factors

Of course, there is no perfect solution or time to make a transfer. It all depends on your preferences, your financial situation, health condition, and more. Overall, however, understanding how exchanges work is key to deciding whether a 1035 is right for your portfolio.

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