What Is a Tax-Free 1035 Exchange?

Al manar
April 17, 2022
A 1035 exchange is a mechanism that allows a taxpayer to replace an annuity or life insurance policy without incurring any tax penalties.

A Section 1035 exchange is another name for it.

Holders of these contracts are permitted by the IRS to conduct this type of exchange in order to replace outmoded contracts with new contracts that offer better benefits, reduced fees, or different investment options.

What Is a Tax-Free 1035 Exchange?
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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  • This is often used to replace outdated contracts with new contracts that have better terms.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 obtaining an annuity, life insurance policy, long-term care product, or endowment, a policyholder may find that the policy is no longer the best fit for their personal or financial circumstances. The Internal Revenue Service (IRS) devised the 1035 exchange to address this scenario, allowing funds to be transferred without incurring tax penalties.

The IRS considers the following insurance contract swaps tax-free: 
  • Replacing one annuity contract with identical annuitants 
  • Replacing one life insurance policy with another life insurance policy, endowment policy, or annuity contract 
  • Replacing one endowment policy with another identical endowment policy or annuity contract
  • The 2006 Pension Protection Act modified the law to allow exchanges into long-term care products.
Despite the fact that a 1035 exchange is tax-free, it is usually reported on a 1099-R form; exceptions include when the exchange occurs within the same firm or when the exchange is a contract-for-contract exchange that does not result in a predetermined distribution.

Exchanges Not Regarded Tax-Free 

Any variation on the above-mentioned allowed exchanges (annuity contract for life insurance) is not considered a tax-free exchange. To qualify for tax-free treatment, the IRS has set tight rules that the owner, insured, and annuitant on the new contract must be the same as they were on the old contract.

To keep the tax-free status, the contract must be exchanged directly between the insurance firms.

In several past decisions, the IRS has determined that if an owner cashes out of an existing contract and promptly applies the funds to a new contract, it is not a tax-free event or a Section 1035 exchange.