Understanding Section 1035 Exchange Rules

If you are looking to exchange an annuity or life insurance policy it’s important to understand the technicalities. We explore the basics of what is a 1035 exchange, how it works, and the rules that may apply.

1035 Exchange Rules

With changes to interest rates and the economy, you may find that your life insurance or annuity isn’t the best option for you anymore. You may want to upgrade your policy to get a better interest rate, for better investment options, to take advantage of better features and benefits, or to better accommodate changes to your family and financial needs. You must change your policy according to Section 1035 Exchange Rules or you might end up owing income taxes on the gains.

When You Might Owe Taxes in Policy Exchanges

With a whole life insurance policy, cash grows tax-deferred. Typically, when you surrender a life insurance policy or annuity, any gains are immediately taxed as ordinary income. Gains are seen when the gross cash value of the contract are greater than the adjusted cost basis of the contract. The adjusted cost basis is the total premiums you’ve paid in cash, adjusted after dividends and tax-free withdrawals you’ve made.

Any cash received in exchanging the policy, including any amount you transferred into a non-qualifying contract, will be taxed at your current income tax rate. You’ll receive a Form 1099-R “Distributions From annuity pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, and Insurance Contracts” and you’ll be required to include the amount as taxable income on your tax return. If your insurance company canceled a loan as part of the transaction, you’ll also be required to report.

Tax Benefits under Section 1035 Exchange

Tax Benefits under Section 1035 Exchange Rules

Under specific circumstances, you can transfer funds from one life insurance policy or annuity to another without being immediately taxed. This exchange is governed by Section 1035 of the Internal Revenue Code. Hence why it’s commonly referred to as “1035 Exchange.” With a 1035 exchange, you’ll be able to avoid federal income taxes, but you may still have to pay any fees or penalties your insurance company charges.

The old insurance policy must be directly exchanged with the new insurance company for the new policy to avoid having the transaction being treated as a sale. That means you can’t receive any proceeds from the transaction. You’re not allowed to receive check from the old insurance company, and then use the proceeds from the check to purchase a new insurance policy. You also cannot have an outstanding loan on the original policy. Or, you can repay the loan or reduce the original policy before making the exchange to avoid a gain.

You are allowed to make a tax-free exchange from one life insurance policy to another, from a life insurance policy to an annuity, and from a deferred annuity to another annuity. However, under Section 1035 exchange rules, you’re not allowed to exchange an annuity contract for a life insurance policy. You’re also allowed to exchange multiple policies for a single policy or a single policy for multiple policies as long as the cost basis of the contract are carried over and adjusted cumulatively.

Under Section 1035 exchange guidelines, the owner of the insurance policy or annuity must remain the same in the exchange. There’s one exception with a policy insurance two lives. The insured in a second-to-die policy can be exchanged for a single life insurance policy after the death of one of the insured individuals.

Section 1035 Exchange Rules

What to Consider Before Exchanging Your Policy

While you may be able to change the policy under Section 1035 exchange rule laws, changing your policy may not necessarily be in your best interest. You should also consider the cost of acquiring a new policy, any surrender penalties you must pay, and the impact of your health status on your new insurance policy. Make sure you’re also aware of any protections in your old policy that aren’t present in the new policy.

If you’re within the surrender period, you may have to pay surrender charges to make the exchange. Early surrender charges may reduce the cash value available toward the new policy. Not only that, the new policy will have its own surrender charge schedule, which may be longer than the schedule of the new policy. The surrender period is the amount of time you have to wait until you can withdraw funds from an annuity without paying a penalty. If you withdraw funds before this period, you’ll have to pay a fee, typically a certain percentage of the annuities value.

The new life insurance policy may have a higher premium than the old one, especially if you started your policy more than five years ago when you have a longer life expectancy. A higher premium doesn’t automatically mean you shouldn’t exchange your policy. However, you should carefully consider whether the benefits of the new policy justify the increased cost.

If you’re planning to exchange your life insurance policy, make sure you’re completely honest on your new application. Being less than truthful on your application could have consequences for your loved ones if something happens to you. The new policy may have a contestability period. During that time, the insurance company can investigate any claims made. The insurance company can check to see if you didn’t disclose everything on your application and deny any claims made against the policy. That period is two years in most states and one year in others.

Is a 1035 Exchange Necessary?

A 1035 Exchange may not be necessary if there’s no gain on the current policy and there’s no outstanding loan on the policy. Whether the 1035 exchange is qualified or non-qualified could play a role. These 1035 Exchanges can take several months and may take more time than you would like to take. You may find it more beneficial to simply pay the surrender fees and deal with the tax consequences doing a non-1035 Exchange.

Only exchange the policy if you’ve determined the new policy is best for you. If you’re interested in exchanging your policy to take advantage of new features or riders, first check to see if these can be added to your currency policy. It may be most cost effective to add riders to your policy than to replace the whole policy. Consulting a qualified insurance professional is the best way to ensure you’re making the switch in the most beneficial and cost-effective way.