A tax-free 1035 exchange is also referred to as a Section 1035 exchange, which involves the replacement of an annuity or life insurance policy for a new one of like kind without incurring any tax consequence for the exchange. The IRS allows holders of these types of contracts to make this type of exchange in order to replace outdated contracts with new contracts that have improved benefits, lower fees, and different investment options.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  • This is often used to replace outdated contracts with new contracts that have better terms.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, life insurance policy, long-term care product, or endowment, a policyholder might determine that their policy might not be the best fit for their particular circumstances, whether those are personal or economic. 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:

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.