What is a 1035 Exchange?

 

A 1035 exchange refers to a section of the U.S. tax code which allows you to exchange an existing annuity contract for a new annuity contract without paying tax on your accumulated income and gains. Tax on your income and gains remains deferred until you commence withdrawals. In addition, if you are younger than age 59 ½, a 1035 exchange enables you to avoid a 10% IRS early withdrawal penalty on the withdrawn profits.

Why Would I Need a 1035 Exchange?

There are a number of reasons why an annuity holder may want to change their annuity and therefore use a 1035 exchange, most of which involve upgrading an annuity to a more favorable one. An investor may wish to change an annuity in order to:

  • Earn higher interest rates.
  • Obtain improved features, such as a larger death benefit.
  • Implement with a change in investment strategy.
  • Access different annuity payout options
  • Access a wider selection of investment choices.

What Does Section 1035 Actually Say?

The specific section of the U.S. tax code is Title 26, Subtitle A, Chapter 1, Subchapter O, Part III, Section 1035, which states:

No gain or loss shall be recognized on the exchange of -

  1. a contract of life insurance for another contract of life insurance or for an endowment or annuity contract; or
  2. a contract of endowment insurance (A) for another contract of endowment insurance which provides for regular payments beginning at a date not later than the date payments would have begun under the contract exchanged, or (B) for an annuity contract; or
  3. an annuity contract for an annuity contract.

The exchange must be performed between the two insurance companies. It is not acceptable for the annuity owner to simply surrender the annuity, receive the cash, and purchase a new annuity.

The annuity owner on the replacement contract must be the same owner as named in the previous contract.

Two or more annuity contracts can be exchanged for a single replacement contract. There is no limit to the number of contracts that can be exchanged for a single contract.

Consider Your Options Carefully Before a 1035 Exchange

You should determine if any penalties or surrender fees will be incurred under your existing contract if you exchange annuities.

Always keep in mind that even though your existing contract may no longer be in the surrender charge period, exchanging that contract for a new one is likely to lock you into a new surrender charge period. Unless you plan to hold the new annuity long-term, you may be better off retaining your existing annuity.

Always consult a qualified independent professional before undertaking a 1035 exchange to ensure the transaction is beneficial and appropriate for your circumstances.

 

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