What Is A 1035 Exchange?

In A Nutshell: IRS Code Section 1035 (a) provides a tax-free method of exchanging an existing life insurance or annuity contract for a new contract with a different company. However, certain requirements must be met. A 1035 exchange permits a contract owner to exchange an older contract for a new contract, as long as the new contract has better benefits and features while deferring income tax on any gain in the existing contract.

What are the basic requirements for a 1035 exchange? The exchange must be 'like-for-like,' meaning that the owner and annuitant/insured must be the same on both policies.

Can a 1035 exchange be used to add funds to an existing policy? In Revenue Ruling 2002-75, the IRS permitted an annuity owner to consolidate two contracts into one Now, many companies permit the use of a 1035 exchange to transfer an entire annuity contract into an existing contract with a different carrier.

Why is the IRS concerned about partial 1035 exchanges? A partial 1035 exchange occurs when an individual transfers a portion of an existing annuity contract into another existing annuity contract or into a new annuity contract. The IRS has indicated that some taxpayers may do a partial 1035 exchange in advance of planned distribution from the contract to minimize income tax on the distribution.

Example: Mr Client purchases a deferred annuity contract from Company 'A' for $100,000. The current value of the contract is $150,000. If Mr Client surrenders the Company 'A' policy and uses the proceeds to purchase a new contract from another company, he will owe income tax on the $50,000 of gain from the existing contract. (The money goes directly to Mr. Client and he deposits into his checking account and write a check to the new company.) Instead, Mr. Client decided to exchange his Company 'A' annuity for a Company 'B' annuity. The money goes direct from Company 'A' to Company 'B' and Mr. Client never sees the money. Mr. Client owes no income tax on the exchange, and his cost basis in the new contract remains at $100,000, which was equal to his basis in the Company 'A' annuity.