As the name suggests, a 1035 exchange is an exchange of contracts covering annuity contracts, life insurance policies, long-term care policies, and endowments. However, there are specific rules and regulations in place to ensure proper processing of the exchange. Therefore, it’s important to understand the guidelines before switching out your policy.
What is the Purpose of a 1035 Exchange?
The primary purpose of the 1035 exchange is to switch out old and outdated products for new ones—it’s essentially a replacement process. But not all replacement transactions are tax-free, though 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.
Which Transfers Are Tax-Free?
Every transfer that falls under the 1035 code is tax-free. But to qualify for tax-free protection, the exchange must be of a specific type under certain conditions. These items include:
- Switching from one annuity contract to another, keeping the same annuitants
- Replacing your life insurance policy with another life insurance or endowment policy or annuity contract
- Changing your endowment policy for an identical endowment policy or an annuity contract
Also, switching products within the same company tends to be an acceptable tax-free route. This is because internal transfers do not require reporting to the IRS as the funds are staying within the same agency.
How to Avoid Tax Costs via a 1035 Exchange
While some situations are tax-free, like those listed previously, there are instances in which your 1035 may incur tax costs.
For example, if you cash out of an existing contract before entering a new one, this will not qualify as a tax-free exchange. To qualify for the tax-free benefit, the contract must go directly from one company to another—no cash-outs included.
You must also keep the same owner, insured member, and annuitant on both contracts to qualify as a tax-free exchange. Therefore, if you need to change any of those items, you won’t be able to achieve a tax-free exchange.
Knowing these specifics ahead of time can help you avoid making a costly tax mistake. However, professional help is advisable before you begin modifying any contract or account.
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.
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.
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.
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.
Potential Drawbacks of a 1035 Exchange
While a 1035 may be great for many situations, there are a few potential drawbacks.
Although the process means you’re moving a contract from one company to another (or, in some cases, within a company), that doesn’t mean you’re off the hook for the first contract. Therefore, your existing company can still charge you surrender fees for ending the relationship early.
However, if you’re performing a transfer between products within the same company, they may waive the fees as you’re not “leaving” the group.
Limits on Transfers
While the exchange must be between two of the same product, such as life insurance for life insurance, some other switches are accepted. For example, you can switch life insurance for a non-qualified annuity.
However, you cannot exchange a non-qualified annuity for a life insurance policy.
But thanks to a modification in the 1035 section of IRS policy, the Pension Protection Act of 2006, you can exchange life insurance policies and non-qualified annuities for both traditional and hybrid long-term care policies.
No Updates to Ownership
One drawback to this type of exchange is that you cannot add or remove contract or policy owners. This means that spouses cannot combine responsibility or benefits on a contract, even if the original policy is in one of their names.
What to Consider Before Making an 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.