Section 1035 Exchange

The exchange of an existing annuity or life insurance policy for new ones at a different insurance company without the penalty of tax is called a Section 1035 Exchange. These exchanges must meet the requirements of the Section 1035 of the Internal Revenue Code for the tax-free status of the exchange. Because of the 1035 Exchange, annuity and life insurance policy owners can exchange their old outdated contracts for newer and more efficient contracts while maintaining the original policy’s tax basis while postponing the gains for federal tax purposes.

To avoid paying taxes now on the earnings of the old contract is one of the reasons to use a 1035 Exchange. Usually when there is a surrender of the existing contract taxes are levied since the owner of the contract will have access to the earnings of the old contract, which becomes current income.

The “old” contract must actually be exchanged for a “new” contract for the transaction to meet the criteria of the 1035 Exchange. It is not enough for the policyholder to receive a check and apply the same money to the purchase of a new contract; the exchange is to take place between insurance companies.

A second reason to use a 1035 Exchange is the preservation of the adjusted basis of the “old” contract. This is especially good for those whose “old” contract has a higher value in the adjusted basis than the actual cash value. The adjusted basis is the total amount of the premiums paid in less any dividends or partial surrenders received. This is important when the owner has a fairly large amount of money invested in the “old” contract.

It is one of the requirements that the owner of the original contract be the same owner of the “new” contract. Once the exchange has been changes in ownership can take place. The types of contracts must be life insurance, or annuity contracts, which have been issued by a life insurance company.

These are the types of exchanges, which are allowed by the Section 1035 Exchange an “old” life insurance policy can be exchanged for a “new” life insurance policy; an “old” life insurance policy can be exchange for a “new” annuity contract; and an “old” annuity contract can be exchanged to a “new” annuity contract.

Several “old” contracts can be exchanged for one “new” contract. There is no limit on the number of contracts to be exchanged for one contract. All the contracts however must belong to the same owner. It is allowed for the death benefit in the “new” contract to be less than the “old” contracts as long as the remaining requirements have been met.

Under the Internal Revenue Code Section 1035, the owner of a deferred annuity can exchange it for an immediate annuity and it will qualify for tax deferral. However, it will depend on the exception under the Internal Revenue Code Section 1035 the owner relies on to avoid the 10%.

A taxpayer can avoid the 10% penalty if the payments are made on or after the date the owner turns 59 1 years old.

One can also avoid the 10% penalty if the payments are part of a series of considerable equal payment made periodic made for the life expectancy of the owner or the joint life expectancy of the owner and the beneficiary.

If the payments are made under an immediate annuity contract for less than the life expectancy of the owner who is under 59 1 years old, will not avoid the 10% penalty.

Section 72 of the Internal Revenue Code requires the immediate annuity payment must begin within one year of the purchase. Since the IRS will most likely insist the purchase date of the “new” contract will be the date of the “old” contract of the deferred annuity. Since it is very unlikely the “old” contract was purchase within one year of the “new” contract, the payments will not quality for this exception.

Section 1035 Exchanges also are used for the exchanging of life insurance policies. There are circumstances where it may be to the owner’s benefit to exchange the existing life insurance policy to a new and improved model. The health status of the owner of the policy could have drastically improved, which would qualify the owner for a cheaper premium because rates of a life insurance policy is based on the health of the insured person.

If the financial situation of the insured party is drastically changed, it might be to the insured person’s advantage to change insurance policy whether it be for a cheaper premium with a less payout amount or a higher premium with a higher payout amount.

You may want to change policies, if you are able to get a better death benefit or if the policy features a better investment opportunity for the owner of the policy.

Because of Section 1035 Exchange, the owner of the policy does not have to cash out the old policy to purchase a new one, and they will also be able to maintain the original basis of the old policy and carry it over to the new policy.

With the Section 1035 Exchange, if you own a cash value life insurance policy and you wish to transfer it to a new life insurance policy you are able to do so. However you can also transfer the life insurance policy to an annuity if you wish. The transfer of an annuity to a life insurance policy is not possible. You would be forced to cash out the annuity, pay the taxes owed, and then you can purchase a life insurance with the same money. These transfers are all tax-free transfers as long as all the rules and guidelines are followed.

The owner of the policy must assign the old insurance contract to the new insurer in exchange for the new contract. Tax-free treatment will not apply if the owner surrenders the previous contract. This is true even if the owner immediately signs the surrender check over to the new insurer or instructs the previous insurer to make the check payable to the new insurer. No checks can exchange hands for the transaction to qualify for the tax-free treatment.

The owner of the policy should compare both policies carefully before making a decision to transfer. Ask to see the “in-force illustration”. This will show the projected cash value and death benefit if the interest rates and death-benefit charges remain at the current level. If the owner will benefit from the transfer of the old policy to the new policy, make sure a Section 1035 Exchange can take place and decide which policy will suit your needs the best.