1035 Exchange

A 1035 exchange is an IRS provision that allows funds to be transferred, without triggering a taxable event, between these three types of savings plans:  life insurance policy, endowment policy, and annuity.  Specifically, a 1035 exchange is allowable from one annuity to another and from a life insurance plan to another life insurance plan or endowment plan or annuity.  It is important to keep in mind that a transfer from an annuity contract to a life insurance plan does NOT qualify as a 1035 exchange and will make the annuity holder responsible for capital gains taxes and surrender charges.

The 1035 exchange is an excellent way to move from a contract with a lower interest rate to a higher one.  However, before you go ahead and make the move, check with your insurance company to understand if there are any penalties or surrender charges that would be imposed on an outbound transfer.

1035 Exchange Rules

The 1035 exchange rules stipulate that partial exchanges in which the investor has no access to the cash value of the annuity, insurance policy, or endowment, may also qualify under the 1035 exchange rule.  This was put into place through a supplemental ruling from Congress, in which they determined that the 1035 exchange is appropriate for “individuals who have merely exchanged one insurance policy for another better suited to their needs and who have not actually realized gain.”
When there is a 1035 exchange from one endowment policy to another, the maturity date of the new policy cannot occur any later than that of the old policy. In other words, the IRS code will not allow the endowment due date to be extended.  Additionally, the individual must complete a 1035 exchange form in order to meet the requirements of the tax benefit.

The title of the 1035 exchange refers to its section of the tax code, in Title 26, Chapter I, Part III. Section 1035 reads, “the exchange, without recognition of gain or loss, of an annuity contract for another annuity contract under § 1035(a)(3) is limited to cases where the same person or persons are the obligee or obligees under the contract received in the exchange as under the original contract.”  In other words, the only way in which the exchange rule can apply is if the insurance, annuity, or endowment policy holder remains the same. It is not a workaround for passing on an estate from one person to another.

Benefits of a 1035 Exchange

Tax savings are the most obvious benefit of the 1035 exchange rule. For example, if an investor buys and sells stocks in different companies, the profits are taxed.  If this activity occurs inside an annuity; however, the investment remains untaxed until the funds are withdrawn for use.

A secondary benefit to investors is that if an annuity with a better interest rate is available, the investor can upgrade to the annuity with the higher interest rate without paying taxes on the funds. This creates an ideal scenario for those actively managing their own retirement funds who want to try to maximize the return without incurring annual tax liabilities.

Drawbacks of the 1035 Exchange

As with any investment, it is important to have your financial advisor help you with the details to ensure that you are making a good exchange. One thing to keep in mind is that some annuity agreements have provisions which allow them to charge penalties or surrender charges for exchanging the annuity prior to the maturity date. As well, the new annuity may obligate the investor to leave their funds invested in that annuity for a longer period of time to avoid additional surrender charges.
Tim Ord
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