How Often Can You Do a 1035 Exchange?
Learn why 1035 exchange frequency is governed by suitability rules, not a set timeline. Understand the requirements to ensure your transfer remains tax-free.
A 1035 exchange, named for a provision in the U.S. Internal Revenue Code, permits the owner of an annuity or life insurance policy to transfer funds from their existing contract to a new one without triggering a taxable event. The purpose is to allow a policyholder to move into a product with more suitable features, lower costs, or better performance without paying income tax on the original policy’s gains. This tax-deferred treatment is a benefit for individuals whose financial needs have evolved since they first purchased their policy.
Rules Governing Exchange Frequency
The Internal Revenue Service (IRS) does not specify a limit on how many times an individual can perform a 1035 exchange or mandate a waiting period between them. Instead, practical limitations on exchange frequency stem from industry regulations and the internal policies of insurance companies. The Financial Industry Regulatory Authority (FINRA) imposes suitability standards on financial professionals who recommend these exchanges. A high frequency of exchanges can be a red flag for regulators, signaling a potentially abusive practice known as churning.
Churning is the act of conducting transactions solely to generate commissions for the broker rather than to benefit the client. Under FINRA Rule 2111, any recommendation to exchange a product must be suitable for the customer based on their financial profile and needs. The financial professional must document that the new contract provides a tangible benefit to the policyholder, such as improved death benefits, lower fees, or new features.
Insurance companies also monitor exchange frequency. When an application for a 1035 exchange is submitted, the new company’s compliance department reviews the transaction. If the client has a history of recent exchanges, the company may request additional justification to ensure the transfer is in the client’s best interest. They may reject applications that lack a clear benefit or suggest a pattern of churning to comply with consumer protection regulations.
Requirements for a Tax-Free Exchange
For a transfer to qualify for tax-free treatment, it must meet two IRS requirements. The first is the “like-kind” rule, which dictates the types of policies that can be exchanged. A life insurance policy can be exchanged for another life insurance policy, an endowment contract, or a non-qualified annuity. An annuity contract can be exchanged for another annuity contract, and both life insurance and annuities can be exchanged for qualified long-term care policies.
A restriction in the like-kind rule is that an annuity contract cannot be exchanged for a life insurance policy. Such a transfer would disqualify the transaction from 1035 treatment, making any gains in the annuity immediately taxable. The cost basis from the original contract, which is the total amount of premiums paid, carries over to the new contract, preserving the tax-deferred status of the growth.
The second requirement involves the ownership structure and the movement of funds. The owner and insured (for life insurance) or annuitant (for annuities) on the new policy must be the same as on the original policy. The funds must also be transferred directly from the old insurance company to the new one. If the policyholder takes personal possession of the money, known as “constructive receipt,” the exchange is voided and all gains become taxable.
The Exchange Process and Key Considerations
The exchange process begins with selecting a new contract that better meets the policyholder’s needs. The applicant then completes the application for the new policy along with 1035 exchange paperwork. This paperwork authorizes the new insurance company to request the funds directly from the existing carrier.
The new insurance company submits the request and required forms to the old company. The old company then processes the request, liquidates the funds from the existing contract, and transfers the money to the new company. Upon receipt of the funds, the new company issues the new policy. The entire process can take several weeks, depending on the processing times of both institutions.
The old policy may be within its surrender charge period, which is a fee for early termination. These charges are deducted from the cash value before the funds are transferred, reducing the amount that goes into the new policy.
The new policy will start its own surrender charge schedule, which could last for several years. For life insurance, the new policy also initiates a two-year contestability period. During this window, the insurance company can investigate and deny a death claim if it finds material misstatements on the application, meaning the benefit is not guaranteed as it was under the older policy.