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 The IRS allows holders of these types of contracts to do this in order to replace outdated contracts with new contracts with improved benefits, lower fees and different investment options.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

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