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What You Need to Know

  • The wrong life insurance or annuity policy can not only be expensive but also leave some clients inadequately prepared.
  • Annuity contract holders can avoid ordinary income taxes if they find one with better terms or are about to end their guaranteed term.
  • Annuities held in a qualified account, such as an IRA, are ineligible for a 1035 exchange, since they’re not taxable.

The right life insurance coverage or annuity policy is key to achieving financial security, but the wrong policy can not only be expensive but also can leave some clients inadequately prepared. 

There are several reasons that a client might own a suboptimal life insurance or annuity policy, including poor advice from a previous advisor or a change in their life circumstances. Changes in life insurance and annuity products, fluctuations in interest rates, and market performance can also prompt a reevaluation of whether an older policy best suits the policyholder’s needs or whether they should look at products from other life insurers.

In those instances, the client may want to sell or surrender their policy to upgrade to a new one. Such a move, however, may have income tax implications. The tax hit will depend on the income tax brackets of the policyholders. In some instances, you can help a client avoid such tax issues by using a 1035 exchange under the Internal Revenue Code. 

Here’s what you need to know about 1035 exchange rules.

1035 Exchange for Annuities

Without a 1035 exchange, the holder of a nonqualified annuity contract would owe ordinary income tax on any annual returns from the nonqualified annuity, plus a 10% penalty for those under age 59½ (in addition to any surrender fees) for an early surrender.

Under the 1035 exchange rules, however, the holder can avoid the ordinary income taxes if they find an annuity contract with better terms or if they’re nearing the end of their guaranteed term.

A 1035 exchange can be particularly valuable for those who’ve had annuities for a long time and amassed significant unrealized capital gains but missed out on some of the features offered by newer annuities. A 1035 exchange will allow them to continue to defer (but not avoid) the capital gains tax.

Heirs who inherit a variable annuity contract can use a 1035 exchange to convert to a different annuity that has better terms, including lower fees, better investment options or additional benefits. It can also allow an annuitant to switch from a variable annuity to a fixed annuity.

Once an annuity owner makes their first annuity withdrawal, the policy becomes ineligible for a 1035 exchange.

(Image: Shutterstock)

1035 Exchange for Life Insurance

With a 1035 exchange for individual life insurance, the policy owner can roll over any surrender proceeds into the new policy to avoid any federal income taxes on the gains in the original policy. The person covered by the life insurance policy typically cannot change, except when the survivor in a second-to-die policy transfers into a single-person coverage.

(Image: Adobe Stock)

1035 Exchange Rules

The IRS provides the detailed regulations governing 1035 exchanges in Section 1035 of the tax code. There are several important rules to keep in mind when helping a client decide whether a 1035 exchange makes sense for their situation:

  • Policyholders can exchange an insurance policy for another life insurance policy, an annuity contract, a long-term care insurance policy, or endowment contracts. They can exchange an annuity for another annuity, but not for life insurance.
  • Partial exchanges are allowed, although a 1035 exchange can also cover the full policy.
  • The owner of the policy cannot take possession of the proceeds during the transfer. Instead, they must roll directly into the purchase of the new life insurance, long-term care insurance policy, or annuity.
  • After the transfer, the original basis for the policy remains, even if the value of that basis is higher than the current cash value of the policy.
  • Annuities held in a qualified account, such as an IRA, are ineligible for a 1035 exchange, since they’re already not taxable.

Conclusion

A 1035 exchange can be a helpful tool for clients who have an insurance policy or annuity that no longer adequately serves their needs. But it’s not the best move for everyone. Contract limitations remain, so holders may still face surrender charges associated with giving up their original policy.

If a client does go through with a 1035 exchange, they typically still need to report the transaction on their taxes using a 1099-R form.

They may need to qualify for a new insurance policy based on their age, health and other factors. By discussing these issues with clients, you can help them decide whether pursuing a 1035 exchange is the best solution for them.

(Image: Shutterstock)

(Image at top: Chris Nicholls/ALM; Adobe Stock)