What is a tax-free 1035 Exchange?

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An Internal Revenue Code Section 1035 "Like-Kind" Exchange (the name is the section of the tax code) is a financial transaction in which a life insurance or annuity policy is replaced for a new one without any taxable event. There are many rules to know in order to successfully make an exchange tax free via Section 1035 of the Internal Revenue Code. FYI - Internal Revenue Code Section 1030 lists a group of exchanges in a series of tax codes that applies to the tax free situations (such as a 1031 Tax Free Exchanges for Real Estate Transaction).

The following exchanges of insurance contracts are considered tax-free by the IRS under Section 1035 such as (most typical):

  • Replacing one annuity contract for another annuity contract with identical annuitants.
  • Replacing one life insurance policy for another life insurance policy or annuity contract (where the insureds/annuitants are the same).

Any other variants are NOT allowed by the IRS.  As an example, you cannot do a 1035 exchange from an annuity to a life insurance contract.  Also, the exchange must be DIRECTLY between the insurance/annuity companies, you can NOT receive any of the cash directly.

Why do this?  Typically when you cash out a cash value insurance policy and/or an annuity, you have to pay taxes (and possibly IRS Penalties if under gate 59 1/2) on the value received that is greater than the tax or cost basis on the policy that is surrendered.  With a 1035 Exchange, you pay no taxes on any gain as the cost basis of the new contract/policy is the basis in the surrendered/exchanged contract (the basis would NOT be the amount deposited into the new policy/contract).  

Thus in a 1035 Exchange you are able to move funds (with rules) between Insurance and annuity contracts without having to pay any taxes or penalties on gains.

Again, the rules are strict.  Any other variation from those acceptable exchanges listed above (such as an exchange from an annuity contract to a life insurance policy) 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.

Why do a 1035 Exchange?

Typically you want to do an exchange as you no longer need the insurance policy or annuity, that you want to change insurance/annuity compnies for a "newer model" or a "better deal" (such as lower costs or provisions that meet your needs now vs. when you purchased the original contract, etc.).

January 2010
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