1035 Exchanges for Life Insurance and Annuities

What do you do if you have a life insurance policy or annuity, and discover that another policy or annuity better meets your needs? Do you have to pay tax on the gains in your old policy before transferring the cash value to a new one?

In many cases, the answer is “no,” thanks to the availability of a “1035 exchange.” The name refers to the section of the Internal Revenue Code that allows the cash value of a life insurance policy to be transferred to a new policy of equal or greater value without taxation of the gains.

The same code section allows a non-qualified annuity to be rolled over to a new annuity of equal or greater value. (A “non-qualified” annuity is one on which contributions to the annuity, but not gains, have already been taxed.) In addition, life insurance cash value can be transferred to an annuity without taxation (but not vice versa).

Why Consider a 1035 Exchange for Life Insurance?

There are a number of reasons that you might want to trade one life insurance policy for another. These include:

  • You’ve identified new life insurance products that offer better premiums or other favorable benefits
  • Changes in your estate planning goals or needs
  • Changes in your business succession planning
  • Concerns about financial instability with your current insurer
  • Economic changes you (the policy holder) have experienced, whether positive or negative
  • Positive health changes, such as significant weight loss or smoking cessation, that allow you to have a better rating with a new policy

Depending on when you acquired your initial policy, you could have significant gains that would be taxable if you simply “cashed out” the policy. A 1035 like-kind exchange to a different variable, universal, or whole-life policy will not only allow you to avoid current taxation on those gains, but will allow your beneficiaries to receive them tax-free after your death.

What if you have a term life insurance policy that you want to exchange for a different policy? Unfortunately, Section 1035 does not apply in this instance. A term life insurance policy has no cash value. If you have questions about the difference between a term and whole-life policy, consult your estate planning attorney or insurance agent.

Section 1035 Exchanges for Annuities

Even more common between life insurance policies are like-kind exchanges between annuities. An annuity is an investment, and if you find a better investment, it makes sense that you might want to transfer funds from one to another. As mentioned above, 1035 exchanges for annuities are only available for non-qualified annuities. The code section does not apply to qualified annuities like traditional IRAs, 401(k)s or 403(b)s, in which contributions to the annuity are made with pre-tax dollars.

You might want to consider an annuity exchange if:

  • The new annuity offers higher interest rates than your old annuity
  • You have a variable annuity and would prefer to avoid volatility by exchanging it for a more conservative fixed annuity
  • A new annuity offers a premium or bonus
  • A new annuity offers desirable features that your old annuity does not
  • The company that holds the annuity contract has become financially weak or unstable

One benefit to a Section 1035 exchange of annuities is that you maintain your cost basis in your original annuity, even if the amount you transfer to a new one is lower. So, if you purchased your original annuity for $120,000, but its value has dropped to $100,000 before you exchange it for another annuity contract, your cost basis in the new annuity is still $120,000.

For some people, the answer to the question “How can I avoid paying taxes on my annuities?” is a 1035 exchange. But it’s important to be aware that while there may be advantages to 1035 annuity exchange, there may also be hidden costs, such as higher annual fees, features you don’t need (but are required to pay for) and commissions. Even if there is a tax benefit to a 1035 annuity exchange, it could be offset by these other expenses, so evaluate the big picture with your attorney or tax professional.

Requirements for a 1035 Exchange

As with most provisions of the Internal Revenue Code that offer savings to taxpayers, there are requirements for Section 1035 exchanges that must be carefully observed. Failure to do so could result in significant tax liability, so it is worth consulting with an attorney or other experienced professional to ensure you have complied with all requirements.

One such requirement is that the funds be transferred directly between institutions, and must not pass through the hands of the policy or account holder. In other words, you can’t cash out one annuity with the intention of buying another, even if you immediately turn around and do so.

Another requirement is that the policy or contract holder in a 1035 exchange be the same. In other words, you can’t transfer an annuity that is in your sole name to one in the names of you and your spouse and expect to reap the benefits of Section 1035.

If you have a loan against your insurance policy, you will likely be required to pay back the loan before you can undertake an exchange under Section 1035. Also, you should be certain that you will be able to purchase the new life insurance policy for which you intend to exchange your old policy; if the new policy is denied, you may be unable to get your old policy back and may have tax liability.

To evaluate whether an annuity or life insurance 1035 is right for you, contact your financial advisor or an experienced estate planning and tax attorney for guidance.