A 1035 exchange is an exchange of similar insurance-related assets. The purpose of the exchange is to avoid taxes that would be due if the insurance consumer redeemed one asset, then purchased the other one in two separate transactions. The term gets its name from Section 1035(a) – (d) of the IRS code, where the ground rules for the 1035 exchange are laid down.
Ground Rules for the 1035 Exchange
Section 1035 of the IRS Code sets the rules for a 1035 Exchange. While the sale of an appreciated asset would ordinarily trigger a taxable event, the IRS Code allows individuals to exchange certain insurance-related assets for each other free of tax, providing that the assets are of “like kind and amount.” The exchange is analogous to a rollover, in that the accrued value in the old asset is withdrawn and used to purchase the new asset. As with a rollover, the consumer should be careful to conduct the exchange as a business-to-business transfer, and without taking constructive receipt of the funds. Otherwise, the tax-free status of the exchange will be revoked.
This provision promotes economic efficiency in two ways. First, it removes a source of inefficiency by allowing consumers to exchange closely-substitutable assets without being artificially deterred by taxation. Second, it enhances competition among sellers of insurance products by making them more substitutable for each other. The consumer might stand to benefit from the exchange for numerous possible reasons. If the old asset is a whole-life insurance policy, for example, the consumer’s health status may have changed since the policy was issued. Cessation of smoking would reduce the premiums on a new policy. Alternatively, a competitive offering from another company might offer better investment value or a higher death benefit. If the financial-strength rating of the consumer’s insurance company declines markedly, the consumer may well want to get a more secure policy by transferring his or her business to a stronger company.
Section 1035 specifically states which insurance products are “like-kind assets.” A life insurance policy can be exchanged for another similar life insurance policy, for an annuity and for an endowment contract. (An endowment contract is an insurance contract geared at least in part to the insured’s life expectancy, but which pays a one-time benefit during the insured’s lifetime.) An annuity can be exchanged for a similar annuity or for an endowment contract. Finally, an endowment contract can be exchanged for another endowment contract. In this case, the new asset must provide for regular payments beginning no later than those of the previous contract. In all cases, the insurance products must be “non-qualifying;” that is, they must not be held inside a tax-advantaged plan such as an IRA or 401(k).
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Participants in a 1035 Exchange pay a bureaucratic price for avoiding taxes by undergoing a lengthy, time-consuming series of steps. First, the consumer must make an application for new insurance, designating a new insurance company as trustee or custodian of the consumer’s funds. Second, the consumer’s application must be reviewed by underwriters if new life insurance is being acquired. (Annuity purchases do not require health underwriting.) Then the new insurance company sends the 1035 Exchange application to the old insurance company, accompanied by a request for the consumer’s funds to be transferred. Next comes a period of “conservancy,” during which the old insurance company has the privilege of seeking to conserve the consumer’s patronage. Insurance companies have been known to delay supplying funds for as long as six months. When their attempts at conservancy prove futile, the old insurance company will send a certified check for the funds to the address supplied on the consumer’s 1035 Exchange application. (The funds should be transferred directly to the new insurance company, without passing through the consumer’s hands.)
For tax purposes, the old insurance company will also provide cost-basis information necessary to compute taxes in the event that the consumer withdraws cash from the new policy. The process picks up speed with a compliance stage, in which the new insurance company verifies that the identities of the insured and the policy owner remain unchanged on the new asset. Once compliance is confirmed, the new policy can be issued. All states incorporate a “free-look period” (lasting anywhere from 10 to 30 days) in which the consumer has the right to reverse the purchase decision without penalty.
Because a 1035 Exchange involves interpretation of the IRS Code and a complicated transfer process, the insurance consumer may benefit from consultation with a financial planner or tax consultant. If life insurance figures in the transfer, the consumer can clarify the comparison of alternatives by obtaining an “in-force illustration” of the projected premiums, cash value and death benefit of the current policy.
An analogue to the 1035 Exchange exists for real property and is described in Section 1031(a) – (h) of the IRS Code. The legislative history of these provisions is intertwined and dates back to the Revenue Act of 1921. In succeeding years, various additions and modifications to both types of like-kind exchanges took place. Important instances in this process occurred in 1954 and the 1980s. The regulations assumed roughly their current form in 1991. In 2002 and 2003, IRS rulings confirmed the eligibility of annuities for 1035 Exchange treatment and added additional detail to the regulations.
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