Tax Consequences of a Non Qualified 1035 Exchange
Failing to meet 1035 exchange rules creates a taxable event. Learn how gain is calculated as ordinary income and how the new asset's cost basis is determined.
Section 1035 of the Internal Revenue Code allows owners of insurance and annuity products to exchange an existing contract for a new one without immediately triggering tax on investment gains. This provision lets policyholders adapt to changing financial needs or move to better-performing products. However, this tax-deferred treatment is contingent upon strict adherence to specific rules.
When these rules are broken, the transaction becomes a “non-qualified” or failed exchange, losing its tax-favored status. This article explores what causes an exchange to fail and the direct tax consequences that follow, which is important for any contract owner to understand to avoid unexpected tax bills.
Defining a Non-Qualified Exchange
The term “non-qualified” can create confusion, as it has two distinct meanings. First, it can refer to a non-qualified annuity, which is a contract funded with after-tax dollars. Exchanging one non-qualified annuity for another is a common and permissible use of a 1035 exchange, where the tax-deferred status of the accumulated earnings is maintained.
The more critical meaning is an exchange that fails to meet IRS requirements for tax-free treatment. A valid exchange must follow several rules, one being that funds must be transferred directly from the old insurance company to the new one. The policy owner cannot receive the funds personally, even temporarily, and then use them to purchase the new contract; doing so constitutes a surrender of the old policy and a new purchase, which is a taxable event.
Another rule is that the owner and the insured or annuitant on the contract must remain the same across both the old and new policies. For instance, an individual cannot exchange a policy they own for a new one owned by their spouse or a trust. Any change in ownership or the person whose life the contract covers will disqualify the transaction from tax-free treatment.
Permitted and Prohibited Exchanges
The Internal Revenue Code outlines which types of “like-kind” contracts can be exchanged for one another to maintain tax-deferred status. These requirements are strict and form the basis of a qualifying exchange.
Permitted exchanges allow for flexibility within similar product categories. An owner can exchange a life insurance policy for another life insurance policy, an endowment contract, or a non-qualified annuity. An endowment contract can be swapped for another endowment contract or a non-qualified annuity, and a non-qualified annuity can be exchanged for another. The Pension Protection Act of 2006 also expanded these rules to permit exchanges from life insurance and non-qualified annuities into qualified long-term care products.
The most significant restriction, and a common reason for a failed exchange, is the prohibition against exchanging an annuity contract for a life insurance policy. This transaction is never permitted on a tax-free basis. The reasoning is to prevent policyholders from converting taxable annuity gains into a tax-free life insurance death benefit. Attempting this swap automatically disqualifies the exchange and makes any gain in the annuity immediately taxable.
Tax Consequences of a Failed Exchange
When an exchange fails to meet the necessary requirements, the tax deferral is lost. The entire gain accumulated within the original contract becomes immediately taxable as ordinary income in the year of the failed exchange. This gain is not treated as a capital gain and is instead taxed at the owner’s marginal income tax rate.
The taxable gain is calculated by taking the fair market value of the surrendered contract and subtracting its cost basis. The cost basis is the total amount of premiums paid into the contract. For example, if a policy owner paid $75,000 in premiums for an annuity now worth $110,000, a failed exchange results in $35,000 of taxable ordinary income.
An otherwise valid exchange can also become taxable if the policy owner receives cash or other non-like-kind property, a concept known as “boot.” If an owner exchanges a policy and receives a partial cash payment, that cash is taxable up to the amount of the total gain in the contract. Similarly, if the original contract had an outstanding loan, the extinguishment of that loan during the exchange is treated as a distribution of boot and is also taxable to the extent of the policy’s gain.
Beyond income tax, a failed exchange involving an annuity can trigger an additional penalty. If the contract owner is under age 59½ at the time of the taxable event, the taxable portion of the distribution is generally subject to a 10% early withdrawal penalty from the IRS. This penalty is levied on top of the ordinary income taxes owed.
Cost Basis and Reporting After an Exchange
The accounting for cost basis in the new policy differs depending on whether the exchange was successful or failed. In a successful, tax-free exchange, the cost basis of the original contract carries over to the new contract. This preserves the original investment amount for tax purposes, and any deferred gain remains inside the new policy.
If the exchange is taxable, the calculation for the new policy’s cost basis changes. The basis in the new contract becomes its fair market value at the time of the exchange because the gain from the old contract has already been taxed. This “step-up” in basis ensures that the previously taxed gains will not be taxed a second time when funds are eventually withdrawn.
The reporting of a failed exchange is handled by the insurance company that administered the original contract. The company will report the taxable event to both the policy owner and the IRS using Form 1099-R. This form will detail the gross proceeds from the transaction and specify the taxable amount, which the recipient is then responsible for reporting on their federal tax return.