What Is a Tax-Free 1035 Exchange?

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 The IRS allows holders of these types of contracts to do this in order to replace outdated contracts with new contracts with improved benefits, lower fees, and different investment options.

Key Takeaways

  • 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  • This is often used to replace outdated contracts with new contracts that have better terms.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 or life insurance policy, a policyholder might determine that the policy held might not be the best fit for his or her particular circumstances. This decision might be based on personal or economic reasons. In this case, the Internal Revenue Service (IRS) has created a 1035 Exchange to allow for the transfer of funds without incurring 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 for another life insurance policy, endowment policy or annuity contract
  • Replacing one endowment policy for an identical endowment policy or an annuity contract

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 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.