What is a tax-free 1035 Exchange?

By Steven Merkel AAA
A:

A Section 1035 Exchange refers to the replacement of an annuity or life insurance policy for a new one without incurring any tax consequence for the exchange. The IRS allows holders of these types of contracts to do this in order to replace outdated contracts with new contracts with improved benefits, lower fees and different investment options.

The following exchanges of insurance contracts are considered tax-free by the IRS:

  • replacing one annuity contract for another annuity contract with identical annuitants
  • replacing one life insurance policy for another life insurance policy, endowment policy or annuity contract
  • replacing one endowment policy for an identical endowment policy or an annuity contract

Any other variation from those acceptable exchanges listed above (annuity contract for life insurance) will not be considered a tax-free exchange. The IRS has provided strict guidelines that the owner, insured and annuitant must be the same on the new contract as listed on the old in order to qualify for the tax-free treatment. The contract must also exchange directly between the insurance companies to retain the tax-free status. The IRS has ruled in several previous cases that if an owner cashes out of a current contract and immediately applies the proceeds to a new contract it will not be treated as a tax-free event or Section 1035 Exchange.

For related reading, check out Update Your Variable Annuity With Section 1035.

This question was answered by Steven Merkel

RELATED FAQS

  1. What is an equity-indexed annuity?

    Understand what an equity-indexed annuity is, its advantages and disadvantages, and how it differs from other annuity investments.
  2. What happens to my annuity after I die?

    Understand the different types of annuity payment plans and what payments or additional benefits are payable to your beneficiaries ...
  3. Who are the best-rated life insurance companies in the US?

    Learn about what makes an insurance company the best. Read about the best life insurance companies in the U.S. in 2014, following ...
  4. What are some examples of when insurance bundling is a bad idea?

    Learn about situations where insurance bundling may not be a favorable option. Bundling insurance is often a good idea, but ...
RELATED TERMS
  1. Subaccount Charge

    Fees charged for the management of an investment fund.
  2. Noncancellable Insurance Policy

    A life or disability insurance policy that an insurance company ...
  3. Policy Or Sales Illustration

    An educational tool that shows a prospective or new insurance ...
  4. Paid-Up Additional Insurance

    Additional whole life insurance that a policyholder purchases ...
  5. Re-Entry Term Insurance

    A type of term life insurance contract that offers low rates ...
  6. Hazardous Activity

    If one of your hobbies falls under an insurance company’s definition ...

You May Also Like

Related Articles
  1. A loan against the cash value of your life insurance isn't the best way to raise money – but sometimes it's the best choice you have. How to decide.
    Insurance

    Should You Borrow From Your Life Insurance?

  2. How to file for a life insurance payout – and how long it takes to receive it. Plus, new ways to plan for payments that provide an income stream.
    Insurance

    Life Insurance: How Long Does It Take ...

  3. The Treasury and the IRS have issued new guidance on pairing annuities with target date funds.
    Investing Basics

    Guidance On Pairing Annuities, Target ...

  4. Compared to other options, does it ever make sense to include cash-value life insurance in your investment portfolio?
    Trading Strategies

    How Good An Investment Is Life Insurance?

  5. Here's how to incorporate life insurance into a plan to ensure that you and your family have the smoothest possible transition into retirement.
    Retirement

    The Smart Way To Use Life Insurance ...

Trading Center