What is Section 1035 Exchange
A 1035 exchange is a requirement in the IRS tax code allowing a tax-free transfer of an existing annuity contract, life insurance policy, long-term care product, or endowment for another one of like kind. Specific rules apply to receive the tax benefits of a 1035 exchange.
Full and partial 1035 exchanges are permitted, however, acceptance, processing, and reporting will vary by company. Typically, 1035 exchanges between products within the same company are not reportable as long as the IRS criteria for the exchange are satisfied.
BREAKING DOWN Section 1035 Exchange
The primary benefit of a section 1035 exchange is the exchange of one product for another with no tax consequence. It also allows contract owners the ability to exchange outdated and underperforming products for newer products with attractive features, such as variable investment options and less restrictive provisions.
Additionally, a section 1035 exchange allows a policyholder to preserve his basis, even if there are no gains to be deferred. For example, Joe Sample invested a total of $100,000 (cost basis) into his non-qualified annuity and subsequently took no loans or withdrawals. Because of poor investment performance, his value dropped to $75,000. Dissatisfied, he decided to transfer his funds into another annuity with another company. In this scenario, the original contract's cost basis of $100,000 becomes the new contract's basis although the lesser cash value of $75,000 was transferred.
How a 1035 Exchange Works
Despite the tax benefits, 1035 exchanges do not absolve the contract owner of their responsibilities to the contract. Surrender charges are typically not waived for 1035 exchanges. However, if exchanged from one product to another within the same company, fees may be waived. The new product from which a modified endowment contract (MEC) was exchanged will also be a MEC. The 1035 exchange does not change that status.
1035 exchanges must occur between products of like kind, such as life insurance for life insurance, non-qualified annuity for non-qualified annuity, and life insurance for non-qualified annuity. However, a non-qualified annuity cannot be exchanged into a life insurance policy. The 2006 Pension Protection Act (PPA) modified IRC section 1035 to include exchanges from life insurance policies and non-qualified annuities into traditional and hybrid (life insurance or annuity) qualified long-term care (LTC) products.
Under a 1035 exchange, the contract owner or policy owner cannot take constructive receipt of the funds and then place them into a new policy. The money must be transferred directly from the holder of the existing product to the holder of the new one. To further qualify, the annuitant or owner or insured or policyholder must remain the same. For example, a 1035 exchange from an annuity owned by Joe Sample cannot be exchanged into an annuity owned by Jane Sample or into a joint annuity owned by Joe and Jane Sample.
Partial 1035 exchanges are becoming increasingly popular as people seek to diversify their holdings. Tax treatment differs for partial exchanges in that a portion of the cost basis is allocated to the new product rather than all of it.