What Is a 1035 Exchange and How Does It Work?

A 1035 exchange, named after Section 1035 of the U.S. tax code, allows policyholders to transfer funds from one insurance or annuity product to another without triggering immediate tax liability on any accumulated gains. The primary purpose of this exchange is to defer taxes, not eliminate them, offering flexibility in managing long-term financial instruments.

Understanding the 1035 Exchange

A 1035 exchange facilitates the tax-deferred transfer of accumulated gains within certain financial products. This means that any growth in the policy’s value is not subject to immediate taxation when moved to a new, qualifying policy. The underlying principle is to allow policyholders to defer taxes that would otherwise be owed if they were to surrender their existing policy and receive the cash value.

The Internal Revenue Code specifies which types of policies qualify for this tax-deferred transfer, focusing on “like-kind” exchanges.

• A life insurance policy can be exchanged for another life insurance policy, an endowment contract, an annuity contract, or a long-term care insurance policy.
• An endowment contract can be exchanged for another endowment contract, an annuity, or a long-term care insurance policy.
• An annuity contract can be exchanged for another annuity contract or a long-term care insurance policy.
• An annuity contract cannot be exchanged for a life insurance policy.

Requirements for a Valid Exchange

For an exchange to qualify under Section 1035 and avoid immediate taxation, strict adherence to IRS rules is necessary. The exchange must be “like-kind,” meaning it involves similar types of insurance products as defined by the IRS.

The insured person or annuitant must remain the same on both the old and new policies. For example, a life insurance policy on one individual cannot be exchanged for a policy insuring a different person. The policy owner must also remain the same throughout the transaction.

The funds must be transferred directly from the old insurance company to the new one. Policyholders cannot take constructive receipt of the funds, meaning they cannot receive a check and then use that money to purchase a new policy. If the policyholder receives any cash or other property during the exchange, known as “boot,” that portion may be immediately taxable to the extent of any gain in the original contract.

Important Considerations Before Exchange

Before initiating a 1035 exchange, policyholders should evaluate practical and financial factors. Existing policies often have surrender charges if exchanged within a certain period, potentially reducing the amount available for transfer. These charges are typically a percentage of the amount invested and decrease over time.

New policies will also come with their own set of fees, charges, and commissions, which can impact the overall value and growth potential. It is advisable to compare the features, benefits, and riders of the new policy with the existing one to ensure it better aligns with current financial objectives. This includes reviewing investment options, administrative fees, and any new surrender periods that may apply.

Determining the suitability of a new policy is another important step. This involves assessing whether the new contract is appropriate for the individual’s age, health, financial situation, and long-term goals. Insurance producers are required to collect specific suitability information, such as annual income, financial objectives, and risk tolerance, to ensure recommendations are appropriate. While a 1035 exchange defers taxes on gains, future withdrawals or distributions from the new policy will still be subject to taxation according to its terms.