1035 Exchange For Annuities [Top 10 Pros and Cons]

What is a 1035 Exchange?

A 1035 Exchange is a transaction whereby the Internal Revenue Service allows you to swap out an existing annuity contract, life insurance policy, qualified long-term care insurance contract, or endowment contract for a new contract or policy that better suits your current situation. The name “1035 Exchange” comes from Internal Revenue Code Section 1035, which authorizes the exchanges.  And, appropriately, the tax implications are what makes 1035 Exchanges important.

Benefits of 1035 Exchange

When the trade takes place, the tax basis of the existing contract transfers to the new contract, and no income or capital gains taxes are owed.  Earnings continue to grow tax-deferred so that you do not owe taxes for the growth until you actually see the money.

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1035 Exchange Example

Say, for instance, you have a whole life insurance policy that has been in place for twenty years and has accrued substantial cash value. At retirement, you decide you no longer need life insurance and instead want to use the policy’s cash value to purchase an annuity contract to help fund your retirement.

Under a 1035 Exchange, the Internal Revenue Service lets you directly trade the whole life policy for an annuity contract without incurring income taxes on the policy’s growth. On the other hand, if you surrendered the policy for cash and used the money to buy an annuity, you would not receive the tax benefits since you would owe taxes on the growth, leaving you with less cash to fund a new annuity contract.

1035 Exchange Options

Section 1035 of the U.S. Internal Revenue Code stipulates that when you exchange certain types of insurance policies for others, you do not incur a gain or loss for tax purposes.

• Specifically, it allows for tax-free exchanges of life insurance policies for other life insurance, endowment, annuity, or qualified long-term care insurance contracts.
• Similarly, you can exchange endowment insurance for another endowment insurance, an annuity, or a qualified long-term care insurance contract.
• You can swap annuity contracts for another annuity or a qualified long-term care insurance contract and a qualified long-term care insurance contract for another of the same type.

The code defines endowment, annuity, and life insurance contracts, emphasizing their characteristics and the conditions under which they may be payable.

Annuitization Clause

Many whole life policies include an annuitization clause, which allows you to elect to receive the policy’s cash value via annuitized payments. While the ultimate result is similar, this is not a 1035 Exchange because the payments are received under the same contract from the insurance company.

By allowing you to swap a whole life policy for a new annuity contract, a 1035 Exchange effectively simulates the benefits of exercising an annuitization clause with an entirely new contract and insurance company.

1035 Exchange Rules

Usually, when you cash out a life insurance policy or surrender an annuity, you owe taxes on any funds you receive above your cost basis (“cost basis” is the aggregate premiums you have paid less any principal withdrawals).  That is, any growth is taxable income. However, if you swap one contract for another through a 1035 Exchange, you do not owe any taxes as a result of the trade.

From a tax policy perspective, the rule makes sense.  If you cash out, you have access to the money and can basically use it for whatever purpose you want.  You could purchase an annuity contract, but you could also buy a new car.

However, if you directly trade one contract for another, your fundamental position (i.e., how much money you have invested in the contract) remains the same – you’re just changing the details as to how you will receive the money.

The Inner workings of the 1035 Exchange

Importantly, when you make a 1035 Exchange, you never actually receive the cash.  It’s exchanged between the existing and new insurance companies. Procedurally, you irrevocably assign the existing policy or contract to the new insurer, who, standing in your place, then surrenders the policy to the insurer that issued it.

Next, the issuing insurer transfers the cash value to the new insurance company, and the new insurance company uses it to fund the new annuity or life insurance policy.

Note, if you surrender the policy, receive a check, and use the money to buy an annuity, the transaction will not be tax-free.

In the Black or In the Red

A 1035 Exchange can be advantageous whether the existing contract is “in the black” or “in the red.” If the cash value is lower than your cost basis, the higher basis will transfer to the new contract, allowing it to accrue greater value before the growth becomes taxable.

For example, let’s say you exchange a whole life insurance policy that has a $20,000 surrender value and a $25,000 basis for an annuity, so it is “in the red”.  The annuity will inherit the $25,000 basis, even though it was only funded with $20,000.  This allows for an additional $5,000 in growth before gains become taxable.

In contrast, if You have a policy with a $25,000 surrender value and a $20,000 cost basis, the policy is $5,000 “in the black.”  If you simply cash out the policy to buy an annuity, you will owe current income tax on the $5,000 in growth.  Each dollar that goes to the IRS results in a corresponding decrease in the annuity premium and, as a result, smaller payments to you.

If you instead execute an annuity 1035 exchange, the entire $25,000 cash value funds the annuity, which then receives the $20,000 cost basis.  The $5,000 growth itself, along with the rest of the annuity premium, continues growing tax-deferred within the annuity.  Income tax will be owed on the growth eventually but not until you’ve actually received the money.

So, rather than getting one big lump-sum tax bill, the taxes are spread out over the life of the annuity, potentially keeping you in a lower tax bracket and resulting in decreased overall tax liability.

Requirements and Qualifications for a 1035 Exchange

To qualify for favorable tax treatment and avoid any tax consequences under Section 1035 of the tax code, the swapped-out contracts must represent a “like-kind exchange.”

Like-Kind Exchange

A Like-Kind Exchange means that the insured or annuitant on the first contract must also be the insured or annuitant on the second contract, and the owner of the contracts must be the same.  Ownership can be assigned after an exchange is completed, but you can’t change the insured.

You can swap out one annuity contract for other types of annuities. All types of annuities, other than irrevocable annuity contracts, are eligible for exchange, including fixed, indexed, and variable annuities.

Between Insurance Companies

As mentioned above, the mechanics of the transaction must occur between the insurance companies, which is why the existing contract is assigned to the new insurance company before the exchange can be completed. To avoid any tax consequences and preserve the tax-advantaged status of the transaction under the tax code, it’s important that the annuitant or insured not receive any of the money that changes hands.

Cannot Split Contract

As long as two or more contracts have the same ownership, they can be exchanged for a single contract, but one contract cannot be split up into multiple new contracts. So, if you have two life insurance policies, you can convert them into a single annuity, but you can’t convert one policy into multiple annuities.

And…

If more than one initial contract is involved, the new annuity or policy’s cost basis is simply the combined bases of the two old contracts.

Surrender Charges May Apply

Depending upon the contract language, the existing insurance company may charge a surrender fee when a 1035 Exchange takes place.  The amount of the fee varies from company to company and usually decreases the longer the contract has been in place. While there might be situations where exchanging an annuity before the end of its surrender period is advantageous, generally, it’s more beneficial to wait until the surrender period concludes to avoid incurring a fee. And your life insurance or annuity provider might eliminate any surrender charges if you’re swapping policies or contracts within the same company.

Outstanding Loans

It is usually preferable to pay off any outstanding loans prior to a 1035 Exchange. If you recently made a withdrawal from your policy or used its values in some way (like paying off a policy loan), be aware that the IRS might consider this withdrawal or use of the policy’s values as taxable income (a/k/a taxable boot) related to the exchange.

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Can you Exchange only a Portion of an Existing Policy’s Cash Value?

A “partial exchange” refers to a transaction in which only some of the value of an existing contract is transferred to the new insurance company. The general rule is that partial exchanges are taxable if the transferred funds can be withdrawn or the contract can be surrendered within 180 days of the transfer.

However, the rule does not apply if the new contract is a single-premium immediate annuity (“SPIA”) providing payments either for life or for at least ten years. Thus, if you exchange a whole life policy for an immediate annuity with lifetime payments, you can immediately begin receiving the annuity payments.

But if the new contract is a deferred annuity, you have to wait at least 180 days before receiving any payments to preserve the tax benefits.

Partial 1035 Exchange

If you execute a partial exchange, the new contract’s basis will be its pro rata portion of the basis of the original contract.

Say you start with a whole life policy worth $100,000 and with a cost basis of $80,000.  Then, you use fifty percent of the $100,000 cash value to purchase a SPIA through a 1035 Exchange.

The basis of the new SPIA will be half the whole life policy’s basis – or $40,000. If you receive a cash distribution of the remaining $50,000 value of the whole life policy, you would have $10,000 in taxable income after deducting the remaining $40,000 basis.

Can you Execute a 1035 Exchange with an Inherited Annuity?

If you inherit an annuity, the IRS permits a tax-free 1035 Exchange for an Annuity, provided certain conditions are met.

• First, the swap must be one annuity for another, and the owner must stay the same.  You can’t use an annuity to purchase a life insurance policy through a tax-free 1035 Exchange.
• And, you can’t exchange your inherited annuity for an annuity for someone else.
• Also, the exchange must be for 100% of the annuity’s value.
• A partial exchange of an inherited annuity is not eligible for Section 1035’s favorable tax treatment.
• And, finally, the new annuity must pay out at least as quickly as the original annuity would have because distributions cannot be extended beyond the inherited annuity’s term.

Pros and Cons of a 1035 Exchange for Annuities

Pros:

1. Tax Deferral: The primary advantage of a 1035 exchange is the ability to defer taxes. When you exchange one annuity for another, the tax basis of the original contract transfers to the new one, ensuring that earnings continue to grow tax-deferred.
2. Adaptability to Changing Needs: A 1035 exchange allows you to adapt your financial products to your current situation without a tax penalty. For example, if your need for life insurance diminishes, you can exchange a life insurance policy for an annuity to provide income in retirement.
3. Avoidance of Tax on Growth: By using a 1035 exchange to switch contracts, you avoid income tax on the growth of the original contract, which could leave you with more funds to invest in the new contract.
4. Preservation of Cost Basis: In a 1035 exchange, you can preserve the cost basis of the original contract in the new contract, which can be advantageous whether the original contract is “in the black” or “in the red.”
5. Flexibility in Contract Exchange: You can exchange various types of contracts, such as life insurance for an annuity or an annuity for another annuity, providing flexibility to meet changing financial goals.

Cons:

1. Limited Exchange Options: You cannot exchange an annuity for a life insurance policy, which limits the types of exchanges you can make.
2. Surrender Fees: The existing insurance company may charge surrender fees when you execute a 1035 exchange, which can reduce the funds available to invest in the new contract.
3. Complex Rules: The rules surrounding 1035 exchanges can be complex, requiring that the insured, annuitant, and owner remain the same, among other qualifications, which might limit your options.
4. Outstanding Loans: Carefully managing the original policy is necessary if it has outstanding loans, as canceled loans during the exchange can result in taxable income or a decreased cost basis.
5. Partial Exchange Tax Implications: Partial exchanges, where you transfer only part of the value of an existing annuity contract, are generally taxable unless you meet specific conditions, adding complexity to the transaction.

Why Consider a 1035 Exchange for an Annuity?

That two-door sportscar you had in college was a lot of fun, but after you got married and had kids, it just wasn’t the right fit anymore.  So, you traded it in for an SUV or a minivan.

That’s the basic idea behind a 1035 Exchange for Annuities –

you swap a financial product that is no longer right for your situation for a product that better suits your current needs.

1035 Exchange for Annuity Example

The classic example is to exchange a life insurance policy’s cash value for an annuity upon retirement.  The dependents who once relied on you for financial support no longer do, so life insurance is no longer essential.

But, rather than cashing out for a lump sum and potentially incurring a big tax bill on the policy’s growth, you might consider spreading the tax liability out over an extended period, while locking in a guaranteed income stream for life and letting the growth continue to earn interest tax-deferred.

Other reasons a 1035 Exchange might make sense.

• Maybe you are in a better position to tolerate risk and want to switch from fixed to variable annuity payments.
• Or, it could be that interest rates have gone up, and insurers are generally paying better returns.
• If your health situation has improved, you may be eligible for lower premiums or a higher benefit with a new life insurance policy.
• Or it could just be that an insurer has started offering a product that perfectly fits your situation.

Nobody’s financial situation stays the same forever.  And I.R.C. §1035 recognizes this fact by allowing you to swap insurance and annuity contracts without taking a tax hit.

Which is why…

If your nearing your retirement age or you are realizing that you may not have saved enough money for your retirement, we would strongly encourage you to give us a call, because it’s quite possible that you may be able to 1035 exchange a life insurance policy or annuity contract for a policy or contract that is much better suited for your needs today and significantly improve your retirement situation! So, what are you waiting for?  Give I&E a call today and see what we can do for you.

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