It also may be referred to as a Section 1035 exchange.
The IRS allows holders of these contracts to make this type of exchange so that they can replace outdated contracts with new contracts that have improved benefits, lower fees, or different investment options.
- A tax-free 1035 exchange is also referred to as Section 1035 exchange.
- A Section 1035 exchange replaces an annuity for a new one without tax consequences.
- This is often used to replace outdated contracts with new contracts that have better terms.
How a Tax-Free 1035 Exchange Works
Years after purchasing an annuity, life insurance policy, long-term care product, or endowment, a policyholder might determine that the policy is not the best fit for their circumstances, personal or economic. To cover this situation, the Internal Revenue Service (IRS) created the 1035 exchange so that the funds can be transferred without triggering tax expenses.
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 with another life insurance policy, endowment policy, or annuity contract
- Replacing one endowment policy for an identical endowment policy or an annuity contract
- The 2006 Pension Protection Act modified the law to allow exchanges into long-term care products.
Although a 1035 exchange doesn't incur taxes, it generally will be reported on a 1099-R form; exceptions include if the exchange occurs within the same company or is a contract-for-contract exchange that doesn't result in a designated distribution.
Funds must pass directly from an old annuity contract to a new one. In other words, the account owner cannot accept a check for an old annuity to buy a new one.
Exchanges Not Considered Tax-Free
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 the annuitant must be the same on the new contract as are 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.