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A 1035 Exchange: What Is It?

Explaining the 1035 Exchange in under five minutes

DEFINITION:
A 1035 exchange is the tax-free exchange of one form of annuity or life insurance contract for another, with the policyholder and insured staying the same.

Read more about this insurance swap, what the conditions are, and if it might be helpful for you.
Important Takeaways
  • A 1035 exchange enables you to switch one form of annuity or life insurance contract for another of like-kind.
  • Exchanging your contracts might be helpful if you can acquire a bigger death benefit, cheaper premiums, or better investing possibilities with the new plan.
  • Whilst making this adjustment doesn’t generate a tax burden, there may be other considerations for the policy owner to consider. This includes possibly higher premiums, surrender costs, and modifications to the conditions.
  • Due of these unintended effects, it’s essential to contact with an experienced practitioner who is acquainted with your case before executing a 1035 exchange.

Definition and Example of a 1035 Exchange?

A 1035 exchange is the tax-free exchange of one form of annuity, endowment, or life insurance contract for another. To fulfill the criteria for this legislation, you must be exchanging an insurance for another of like-kind.

Following are some frequent forms of trades that qualify:

  • A life insurance policy to another life insurance policy
  • A life insurance policy to an annuity
  • An annuity to another annuity
  • A long-term care insurance policy to another long-term care insurance policy
  • An annuity for a long-term care insurance policy
  • A contract of endowment insurance for an annuity

For example, if you had an annuity with a lower interest rate you might utilize the 1035 exchange to shift to an annuity with a greater rate. You might also trade out the cash worth of an old life insurance policy for a lower paid-up insurance policy. Then you wouldn’t have to continue paying premiums.

Nevertheless, not all sorts of transactions qualify under Section 1035. The legislation specifies that you can’t move from an annuity to a life insurance coverage. To accomplish so, you’d have to renounce your annuity, pay any capital gains taxes, and then acquire the new life insurance policy. 

Note
A 1035 exchange involves rigorous regulations, and there may be additional tax repercussions. If you’re contemplating trading in one of your policies for another, it’s advisable to receive advice from a knowledgeable specialist.

How a 1035 Swap Works

A 1035 exchange is derived from section 1035 of the Internal Tax Code. This clause enables policyholders to transfer their monies from one form of life insurance contract or annuity to another provided certain requirements are satisfied.

To qualify for a 1035 exchange, you must fulfill two primary conditions.

First, the contract that is being exchanged needs to be of “like-kind” with the new one. In other words, the new policy cannot be materially different from the previous one in terms of its essence and character. This implies the policyholder and the insured person's name must keep the same. You can’t utilize this technique to transfer ownership of an insurance.

Second, the funds from the previous insurance have to go into a new one. You can’t utilize them as cash or premium payments for another sort of coverage.

Note
You can’t utilize a 1035 exchange to swap the cash value of a permanent life insurance policy for a term life insurance policy. You must stick to policies of like-kind.

Let’s imagine you acquired a variable non-qualified annuity early in your career when you had a larger risk tolerance but now you are nearing retirement. You wish to move to a fixed annuity that can deliver more predictable income.

With the aid of your financial adviser, you fill out the relevant papers and utilize a 1035 exchange to replace your old annuity for a new one. If you have financial gains from this annuity, you may transfer them completely into the new insurance without incurring capital gains taxes.

Note
Study the terms and conditions of your new insurance carefully before making the move. You may have a new contestability period or higher premiums. 

Benefits and Disadvantages of a 1035 Exchange

A 1035 exchange can provide tax benefits if you wish to change plans, but there are some negatives to consider as well.

Pros

  • Can alter your policy
  • Tax-free trade
  • You may switch to a different insurance provider

Cons

  • Doesn’t work well with loans
  • May need to pay a surrender fee
  • Possible higher premiums 

Pros Explained

  • Can alter your policy: A life insurance policy you bought when you were young may not be a perfect match for you now. Over time, interest rates might fluctuate, new products can launch, and you might wish to switch to a policy with better terms.
  • Tax-free exchange: If your 1035 transaction qualifies, you won’t have to pay any taxes, even if you’ve got profits.
  • You may switch to a different insurance company: If you have reservations about your insurer, you may utilize a 1035 exchange to purchase a coverage with a different carrier.

Cons Explained

  • Doesn’t work well with loans: If you have an existing debt on your insurance policy, a 1035 becomes tricky. It’s advisable to pay back the loan before you make the trade.
  • May need to pay a surrender fee: If you make the trade too soon, you may need to pay surrender costs, which limit profits.
  • Possibly higher rates: If you are swapping a life insurance policy that you acquired it when you were younger and healthier, you may have higher premiums. If your status has changed, it may be tougher to acquire an insurance with the same terms. Be prepared to spend extra.