1035 Exchanges Explained

An annuity policy that was appropriate for a purchaser at one point in time may not always be the best investment option at a later date. Financial situations change as investors age. In addition, annuity companies are continuously updating their products to meet changing market needs. As a result, an annuity may become outdated for the annuitant, or it may just be underperforming. At some point in time, an investor may find that he would like to exchange his annuity contract for a new one.

If this is the case, there are some situations where the exchange could qualify for favorable tax treatment. A Section 1035 Exchange allows an investor to swap an existing annuity policy for a new one without tax consequences. The exchange must take place between two different insurance companies for it to qualify for the tax benefit.

A person would want to use a 1035 exchange for the following reasons:
• To avoid taxation on the gain in the original contract.
• To preserve the adjusted basis, which is the sum of premiums paid minus the dividends received, in the original contract.

For an exchange to qualify as a 1035 exchange, several guidelines must be met. The annuitant for the new contract must be the same as the one for the original contract. The actual exchange must happen directly between the two insurance companies. If the purchaser surrenders the old contract, receives a check, and then invests in a new contract, this exchange will not qualify as a 1035 Exchange.

If these guidelines are not met, the exchanged will not be considered a 1035 exchange and the proceeds from the original contract will be taxed as ordinary income.

Life insurance and endowment contracts, in addition to annuity contracts, are eligible for the favorable tax treatment. The types of the new and original contracts do not need to be the same. For example, a holder could have a life insurance contract that they would like to exchange for a new annuity contract. This exchange is allowed. However, an investor cannot exchange an original annuity contract for a new life insurance contract.

There is also flexibility in the number of contracts that can be exchanged. Two or more original contracts can be exchanged for a new contract as long as the owner is the same on all of the original contracts.

It is important to know that there are times when it might be better to surrender the original policy than to perform a 1035 Exchange. If there is no gain on the original contract, a 1035 Exchange would not offer an advantage unless the annuitant wanted to preserve the adjusted basis in the contract. A 1035 Exchange is a time consuming process and can take several months to complete.

Some insurance companies offer incentives to switch between companies so it is important for the purchaser to consider all of his options in addition to his financial position when deciding whether to enact a 1035 Exchange.