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Understanding Annuity 1035 Exchange Rules

What is a 1035 Exchange?

The Internal Revenue Service (IRS) allows you to exchange an annuity policy that you own for a new annuity policy without paying tax on the investment gains earned on the original contract. This can be a substantial benefit. 

This rule is governed by Section 1035 of the Internal Revenue Code which is why these are called “1035 Exchanges.”

Below is a direct link to the complete text of the code.

U.S. Code > Title 26 > Subtitle A > Chapter 1 > Subchapter O > Part III > Section 1035

1035 Exchange Rules

  • There are a couple of important rules that must be followed in order to receive the benefits of a 1035 Exchange.
  • The tax code says that the old annuity policy must be exchanged for a new policy – you cannot receive a check and apply the proceeds to the purchase of a new insurance policy.

The tax code also says that you can make a tax-free exchange from: 

  1. a life insurance policy to another life insurance policy or
  2. a life insurance policy to an annuity

You cannot, however, exchange an annuity contract for a life insurance policy.

As a result of the Pension Protection Act of 2006 (PPA), you may now also use a 1035 exchange to exchange an annuity for a qualified long term care plan.

A transaction in which a new insurance or annuity contract is to be purchased using all or a portion of the proceeds of an existing life insurance or annuity contract is referred to as a “replacement.” A 1035 Exchange is a type of replacement transaction. Although the term “1035 Exchange” is often used to describe any form of replacement activity, technically not all replacements are Section 1035 Exchanges and as a consequence are not tax-free.

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1035 Exchange Annuity

A 1035 Exchange is executed by completing and submitting 1035 paperwork along with your annuity application. Typically the 1035 paperwork is two pages, one of which is all legalities and disclosures. The second page requires information regarding your existing annuity and insurer, including: 

  • Insurance Company
  • Annuity Policy #
  • Type of annuity
  • Address
  • Phone Number

Here is an example of a 1035 Exchange form for your reference.

You will also be required to complete Replacement Paperwork which is most often two pages as well.  The replacement paperwork is also very simple and simply requires basic information about the existing annuity policy and the proposed one.
 

Most insurance companies require a product comparison as part of their replacement paperwork. This is mostly to be sure the proposed 1035 exchange is suitable. Here is an example of a replacement form.

Once you’ve submitted your annuity application along with the 1035 Exchange and Replacement paperwork your funds will be transferred directly from custodian to custodian. You will never take possession of the funds and as a result, you can maintain tax-deferral without any consequences.

Advantages of a 1035 Exchange

The primary advantage of using a 1035 exchange to change your life insurance policy or annuity choices is to avoid triggering taxes on those transactions. There are different scenarios where exchanging policies or annuity contracts might make sense. For example, advantages of a 1035 exchange include:

  • You need more life insurance coverage than you currently have
  • You want to change the type of life insurance policy you have
  • You’re looking for an annuity contract with lower fees
  • You want to restructure your annuity payments
  • You currently own a variable annuity and your risk tolerance has changed

As long as you’re exchanging contracts within the guidelines set by the IRS you all of the above events will be tax-free to you. 

Factors to Assess When Considering a 1035 Exchange

  • What was your goal or objective when you originally purchased your annuity?
  • Have your goals or objectives changed?
  • Will the new annuity better meet your current investment goals and objectives?
  • Does the new annuity have higher interest rates, less fees, a better guaranteed death benefit, or pay more lifetime income?
  • Will you have to pay a surrender fee to transfer your existing annuity or is it out of surrender?

1035 Exchange Fees

There are no specific fees associated with a 1035 exchange. However, there may be fees for getting out of your existing annuity in the form of surrender fees that are typically not waived for 1035 exchanges.

However, some insurers will allow you to transfer from one annuity to another one of their policies without a surrender charge; these are called an Internal Exchange. Almost all deferred annuities allow you to annuitize (turn into income) during the surrender period without any fees.

Partial 1035 Exchange

Partial 1035: The basis and income will be split pro-rata between the two contracts, which creates a potential for abuse. So the IRS has placed additional rules for these types of exchanges.

To qualify as a tax-free partial 1035 exchange, clients may not take a distribution from either contract within 180 days of the exchange. The IRS may treat a distribution in this time period as being a part of the original transaction. That causes the full amount of income from both contracts (up to the amount that was distributed) to be taxable, as opposed to only taxing income from the contract that distributed the funds.

Taking a distribution from either contract within 180 days of a partial 1035 is likely to be scrutinized by the IRS as a tax avoidance device and may result in higher taxes, penalties, and fees. An exception to the 180-day rule is if the distribution is received as an annuity for life or a period of 10 years or more.¹

Source:   1. Principal Advisors Advanced Markets

Frequently Asked Questions

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My Annuity Store Can Assist You

We have assisted many clients with the 1035 exchange process. We help collect information and assess if a 1035 exchange into a new policy would better meet your needs.

The process is more cumbersome and time-consuming since you have to comply with two different insurers’ business processes. The incentive for your existing annuity provider to make the process easy is especially low, which presents its own unique challenges. The My Annuity Store’s new business team can help navigate different insurers in order to ensure you provide the required information to both insurers so the transaction goes smoothly.

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Kiara Caudill

I spent the first 10 years of my career as a clinical mental health therapist and I saw firsthand that finances play a large role in one’s happiness. A good financial plan is not only important to your financial health it’s also important to your mental health. I approach financial planning from a behavioral finance perspective using a goals-based approach. Kiara holds a B.A. Degree in Psychology from Goshen College and an M.A. in Clinical Mental Health Counseling from Valparaiso University.

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