What Is a 1035 Exchange? Rules, Requirements, and Tax Treatment
Americans own individual life insurance with a total face value of $13.6 trillion.¹ With that much coverage in force, it’s common for policyholders to eventually find that their current life insurance policy or annuity contract no longer fits their needs.²
When that happens, many people want to exchange their policy or contract for a better-suited one, without triggering a taxable event. That’s exactly what a 1035 exchange allows.
What Is a 1035 Exchange?
A 1035 exchange refers to Section 1035 of the Internal Revenue Code, which allows you to exchange an annuity contract or life insurance policy without the exchange being treated as a sale or surrender for tax purposes.
Key requirement: A 1035 exchange can only be used when the exchange involves:
- The same contract or policyholder, and
- The same type of product (for example, life insurance for life insurance, or annuity for annuity)
1035 Exchange Life Insurance and Annuity: Trading In an Older Policy
Provided certain requirements are met, a 1035 exchange gives policy or contract holders the flexibility to “trade in” an older policy or contract for a newer one. A newer 1035 exchange annuity or life insurance policy may offer:
- Lower costs
- A higher death benefit
- More investment choices
1035 exchanges involve a complex set of tax rules and regulations. Before moving forward, it’s wise to work with a tax professional who is familiar with 1035 exchange requirements and rules.
What Is Not Allowable in a 1035 Exchange?
To qualify for 1035 exchange tax treatment, the exchange generally must:
- Involve the same policyholder or contract owner on both the old and new contract
- Exchange like-for-like product types (you cannot, for example, exchange a life insurance policy for a different, unrelated financial product)
Because the rules are detailed and fact-specific, a tax professional should confirm whether your specific exchange qualifies before you proceed.
Partial 1035 Exchange
Individuals also have the option to complete a partial 1035 exchange, moving only a portion of the total contract value rather than the entire contract.
With a partial exchange, any gain may be subject to ordinary income tax when it’s eventually withdrawn. Because of this, a tax professional should always be consulted before completing a partial 1035 exchange.
Key Considerations Before a 1035 Exchange
Life Insurance Considerations
Several factors affect the cost and availability of life insurance, including:
- Age
- Health
- The type and amount of insurance purchased
Keep these points in mind as well:
- Life insurance policies carry expenses, including mortality and other charges.
- Surrendering a policy prematurely may result in surrender charges and income tax implications.
- You should confirm your insurability before implementing any strategy involving life insurance.
- Any guarantees associated with a policy depend on the claims-paying ability of the issuing insurance company.
Annuity Considerations
Annuities have contract limitations, fees, and charges, including:
- Account and administrative fees
- Underlying investment management fees
- Mortality and expense fees
- Charges for optional benefits
Additional points to know:
- Most annuities carry surrender fees, which are typically highest if funds are withdrawn in the early years of the contract.
- Withdrawals and income payments are taxed as ordinary income.
- Withdrawals made prior to age 59½ may be subject to a 10% federal income tax penalty, unless an exception applies.
- Annuity guarantees depend on the issuing company’s claims-paying ability. Annuities are not guaranteed by the FDIC or any other government agency.
Variable annuities are sold by prospectus, which contains detailed information about investment objectives, risks, charges, and expenses. Read the prospectus carefully before you invest or send money to purchase a variable annuity contract; it’s available from the insurance company or your financial professional. Variable annuity subaccounts fluctuate in value based on market conditions and may be worth more or less than the original amount invested if the annuity is surrendered.
Working With a Financial Professional in Southwest Florida
Because 1035 exchange rules involve detailed tax and contract requirements, Fort Myers and Southwest Florida policyholders considering an exchange should work with a qualified financial and tax professional to review their specific policy or contract before making a change.
Frequently Asked Questions
What is a 1035 exchange?
A 1035 exchange is a provision under Section 1035 of the Internal Revenue Code that allows you to exchange an annuity contract or life insurance policy for a new one without the transaction being treated as a taxable sale or surrender.
What is a 1035 exchange annuity?
A 1035 exchange annuity is an annuity contract exchanged for a new annuity contract under Section 1035, allowing the contract holder to switch products without triggering immediate income tax on any gain, provided requirements are met.
What is 1035 exchange life insurance?
1035 exchange life insurance refers to exchanging one life insurance policy for another life insurance policy under Section 1035, allowing the policyholder to trade in an older policy for one with different features, such as lower costs or a higher death benefit, without a taxable event.
What is not allowable in a 1035 exchange?
A 1035 exchange is not allowable when the product types don’t match (for example, exchanging life insurance for a non-qualifying product) or when the contract or policyholder is not the same on both the old and new contract. A tax professional can confirm whether a specific exchange qualifies.
Can I do a partial 1035 exchange?
Yes. A partial 1035 exchange allows you to exchange a portion of a contract’s value rather than the full amount. Any gain may be subject to ordinary income tax upon withdrawal, so consulting a tax professional beforehand is recommended.
How is a 1035 exchange taxed?
When completed correctly, a 1035 exchange itself is not a taxable event. However, the tax rules are complex, and future withdrawals or gains may still be subject to ordinary income tax. A tax professional should review your specific situation.
1. American Council of Life Insurers, ACLI Fact Book.
2. Endowment contracts and qualified long-term care contracts also may be eligible for a 1035 exchange. A tax professional should be consulted before considering an exchange.
The content is developed from sources believed to be providing accurate information. The information in this material is not intended as tax or legal advice. It may not be used for the purpose of avoiding any federal tax penalties. Please consult a legal or tax professional for specific information regarding your individual situation. The opinions expressed and material provided are for general information and should not be considered a solicitation for the purchase or sale of any security.
