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What Is a 1035 Exchange?

Tip: Long-Term Coverage. 1035 exchanges can be used to exchange a life insurance policy, modified endowment contract, or an annuity contract for a long-term care policy. That means that an old life insurance policy may provide coverage for long-term care. Consult a tax professional before considering an exchange.
Source: Internal Revenue Service, 2014

According to the most recent information available, Americans had individual life insurance with a total face value of $11.2 trillion.1

Due to a variety of factors, these individuals may find themselves in circumstances where the specific life insurance policy or annuity contract they own does not suit their needs.2 They may want to exchange products without incurring a taxable event.

That’s where Section 1035 of the Internal Revenue Code comes in. A 1035 exchange provides a means for exchanging an annuity contract or life insurance policy without being treated as if it had been surrendered or sold. Keep in mind that a 1035 exchange can be used only when it involves the same contract or policy holder and the same type of product.

Trading-In an Older Policy

A 1035 exchange, provided certain requirements are met, gives policy or contract holders the flexibility to “trade-in” an older contract or policy for a newer contract or policy. A newer policy or contract may have lower costs, a higher death benefit, or more investment choices.

1035 exchanges involve a complex set of tax rules and regulations. Before moving forward with a 1035 exchange, consider working with a tax professional who is familiar with the rules and regulations.

Partial Exchanges

Fast Fact: Surrender Charge Caution. If you own an annuity contract that is still in the surrender charge period, you may
be required to pay the surrender charge when undertaking a 1035 exchange. And your new annuity contract may be subject to its own surrender charge period—which may be longer than the remaining period on the old contract.
Source: Securities and Exchange Commission, 2014

Also, individuals can do a partial 1035 exchange for a portion of the total contract. A tax professional should be consulted for a partial exchange because any gain may be subject to ordinary income tax when withdrawn.

Several factors will affect the cost and availability of life insurance, including age, health and the type and amount of insurance purchased. Life insurance policies have expenses, including mortality and other charges. If a policy is surrendered prematurely, the policy holder also may pay surrender charges and have income tax implications. You should consider determining whether you are insurable before implementing a strategy involving life insurance. Any guarantees associated with a policy are dependent on the ability of the issuing insurance company to continue making claim payments.

Annuities have contract limitations, fees, and charges, including account and administrative fees, underlying investment management fees, mortality and expense fees, and charges for optional benefits. Most annuities have surrender fees that are usually highest if you take out the money in the initial years of the annuity contact. Withdrawals and income payments are taxed as ordinary income. If a withdrawal is made prior to age 59½, a 10% federal income tax penalty may apply (unless an exception applies). The guarantees of an annuity contract depend on the issuing company’s claims-paying ability. Annuities are not guaranteed by the FDIC or any other government agency. The earnings component of an annuity withdrawal is taxed as ordinary income and, if taken before age 59½, may be subject to a 10% federal income tax penalty. Annuities have fees and charges associated with the contract, and a surrender charge also may apply if the contract owner elects to give up the annuity before certain time-period conditions are satisfied.

Variable annuities are sold by prospectus, which contains detailed information about investment objectives and risks, as well as charges and expenses. You are encouraged to read the prospectus carefully before you invest or send money to buy a variable annuity contract. The prospectus is available from the insurance company or from your financial professional. Variable annuity subaccounts will fluctuate in value based on market conditions, and may be worth more or less than the original amount invested if the annuity is surrendered.

Permitted Exchanges

While a life insurance policy may be exchanged for another life insurance policy, a modified endowment contract, an annuity contract, or a long-term care policy, the reverse is not true. This chart details the exchanges permitted under a 1035 exchange.

Permitted Exchanges

Source: Internal Revenue Service, 2014

  1. American Council of Life Insurers, 2013; as of December 31, 2012, the most recent data available.
  2. Endowment contracts and qualified long-term care contracts also may be eligible for a 1035 exchange. A tax professional should be consulted before considering an exchange.

The content is developed from sources believed to be providing accurate information. The information in this material is not intended as tax or legal advice. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. Some of this material was developed and produced by FMG, LLC, to provide information on a topic that may be of interest. FMG, LLC, is not affiliated with the named broker-dealer, state- or SEC-registered investment advisory firm. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security. Copyright 2014 Faulkner Media Group.

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