TL;DR: Understanding a 1035 exchange is essential when upgrading life insurance or annuity products without triggering taxes. This guide explains the rules, limitations, and risks so you know exactly what’s allowable—and what isn’t—before making a switch.
Main points:
- What a 1035 exchange is and how it enables tax-free swaps of life insurance, annuities, and similar products.
- Key rules, including like-kind requirements, ownership consistency, and why exchanges must be handled directly between institutions.
- What is not allowable in a 1035 exchange, such as real estate, cash withdrawals, or switching to unrelated financial vehicles.
- How non-qualified 1035 exchanges work for after-tax annuities and insurance.
- The main disadvantages—like surrender charges, loss of riders, and potential fees—to evaluate before exchanging a policy.
Are you looking to swap your old life insurance policy for a newer one? You may want better annuity terms for your retirement. When you know what is not allowable in a 1035 exchange, you can make smarter financial decisions. This is especially true when managing life insurance and annuity products.
A 1035 exchange lets you replace one insurance or annuity contract with another without paying taxes on gains. However, not every swap qualifies, and breaking the rules can cause major problems. This guide explains what’s not allowable in a 1035 exchange and how to protect yourself during the process.
What Is a 1035 Exchange?
If you’re unsure what a 1035 exchange is, this will make it simple to understand. A 1035 exchange is a tax-free swap of an insurance policy or annuity product for another. The name comes from Section 1035 of the IRS code. A 1035 exchange allows you to upgrade a policy or move into a better product without triggering capital gains taxes. This gives you room to improve your financial plan without taking a tax hit.
1035 exchange Rules You Should Know
You must follow several 1035 exchange rules to keep the exchange tax-free. Breaking these rules can create taxes, fees, and contract problems.
1. 1035 Exchanges Apply to Specific Types of Property
There are two types of exchanges that allow the exchange of property while deferring capital gains taxes:
- 1031 exchange
- 1035 exchange
It’s easy to get confused between the two.
The former was designed for real estate transactions. This means you wouldn’t use a 1035 for real estate exchanges. By law, you can’t use a 1035 exchange for real estate. A 1035 exchange was made specifically for a few types of products, including:
- life insurance policies
- annuities
- endowment contracts
Any attempt to involve real estate is not allowable and disqualifies the exchange.
2. Exchanges Must Be Made to Like-Kind Property (with Some Exceptions)
The IRS requires that a 1035 exchange involve similar product types. A life insurance-to-life insurance exchange qualifies. Annuity-to-annuity exchanges qualify too.
You can see the same when swapping one annuity for another annuity. This helps maintain the tax-deferred status of the investments. Switching between two different kinds of vehicles is not allowable in a 1035 exchange. For example:
- You can’t make a 1035 exchange for life insurance to an annuity that is qualified.
- You can’t swap unrelated financial vehicles.
However there are exceptions to this 1035 exchange rule, such as:
- a life insurance policy to a non-qualified annuity
- a life insurance policy to a long-term care insurance
- a life insurance policy to an endowment
- a non-qualified annuity to a long-term care insurance
- an endowment to a long-term care insurance
- an endowment to a non-qualified annuity
These exceptions are complex. The IRS does not allow a 1035 exchange life insurance to annuity in every situation, so guidance is important. You can make one from a life insurance policy to a non-qualified annuity. It’s always best to seek assistance from a financial professional to navigate these 1035 exchange rules.
3. The Owner Must Be the Same for both Contracts
The same person or entity must own both the old and new contracts. Transferring ownership of the financial product from one person to another is not allowed in a 1035 exchange. Ownership must remain the same throughout the entire exchange, and the new policy should have benefits like the old one.
These 1035 exchange rules ensure the policyholder's benefits and obligations remain consistent, making the exchange fair and straightforward. For example, a 1035 life insurance exchange would require you to own the old and new policies. A change in ownership would disqualify the exchange from its tax-free status, so keep this in mind.
4. Institutions Handle This Directly
Exchanging a policy for cash or taking withdrawals is not allowable in a 1035 exchange. Any cash taken out could be seen as income and trigger taxes on any gains. The transaction must also be a direct swap from one institution to another institution.
Some partial exchanges may be accepted with annuities but be sure to consult with a financial advisor before you make a switch. You must consider capital gain taxes and surrender charges. A 1035 exchange is of little value if the surrender charges on your contract override the gains made.
What Is a Non-Qualified 1035 Exchange?
A 1035 exchange for a non-qualified annuity refers to a tax-free exchange involving annuities or life insurance funded with after-tax dollars. These are not inside a tax-advantaged account like a 401k or IRA.
“Non-qualified,” in this instance, means the funds in the annuity or insurance policy were contributed with after-tax dollars. This is unlike qualified accounts, where contributions are made with pre-tax dollars.
This makes the tax-free exchange especially useful because you keep tax-deferred growth without triggering extra taxes.
What Are Possible Disadvantages of a 1035 Exchange?
These are some disadvantages of a 1035 exchange:
- 1035 exchanges surrender charges may apply when you exit the old contract. The new contract may also start a fresh surrender period.
- You may lose guaranteed rates or riders from your current policy.
- You may face fees or unexpected costs if the exchange is not handled correctly.
- A new contract may not align with your estate plan or long-term financial goals.
Always review the fine print before making the switch.
Make the Right Moves for Your End Game
Work with the team at Asset Preservation Wealth and Tax to choose suitable policies and financial vehicles for you. Our experts assess your goals and objectives to achieve short and long-term needs. Our holistic approach considers everything from taxes to estate planning so you can get a big-picture approach to your financial decisions. Leave no stone unturned with our professionals by your side.
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Stewart Willis is the founder and president of Asset Preservation Wealth & Tax, a financial planning firm in Phoenix, Arizona. Investment advisory services offered through Foundations Investment Advisors, LLC, an SEC registered investment adviser.
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