A 1035 exchange is a way for taxpayers to take funds from one life insurance policy, annuity or similar arrangement and put them in another of the same type without owing tax to the Internal Revenue Service on any gains. It's somewhat similar to rolling money over from one retirement plan to another without a tax penalty. If you decide to do a 1035 exchange, authorized by Section 1035 of the tax code (not, as some believe, any IRS tax form 1035), make sure you and the companies involved follow the rules to avoid any surprise tax bill.
In the event that you complete a 1035 exchange, you will be required to to complete IRS Form 1099-R. Exceptions to this rule may occur if your new policy or annuity is held by the same company as the one you are transferring funds from.
Surrender Values and Tax Gains
If you are the holder of an annuity or life insurance policy, you will typically pay into the policy over a period of your life, generally measured in the decades. With a life insurance policy, your heirs then receive a payment from the insurance company when you die based on the terms of the contract. For an annuity, you receive payments during your lifetime after a certain period of time, usually during your retirement.
It's often possible to surrender a life insurance policy or an annuity, essentially selling the policy or annuity back to the company who sold it for a cash value. If this value is more than you paid into the policy, the amount known as the cost basis, the difference can be taxable income in the eyes of the IRS.
In this situation, you'll likely receive a copy of IRS Form 1099-R from the insurance or annuity company specifying how much is taxable income. Include it when you file your tax return and consult the IRS's Form 1099-R instructions for help understanding any notes on the form.
Consider the tax ramifications of surrendering or otherwise transferring an annuity or life insurance policy as one of the factors in making such a decision.
Making a 1035 Exchange
In some cases, you might have an annuity, life insurance policy, long-term care insurance policy or similar plan that you effectively want to replace. That is, you still want to carry life insurance or reap the benefits of an annuity, but you know you can get better terms from the same company or a rival.
If you simply surrender your old life insurance policy or annuity and sign a contract for a new one, you may see an unwelcome tax bill if the surrender value does, in fact, exceed your cost basis. To prevent this from keeping people locked into undesirable financial planning situations, Section 1035 of the tax code allows you to effectively exchange one annuity or policy for another. This process is called a Section 1035 exchange. Your cost basis in the new annuity or policy will be considered to be the same as your previous cost basis.
To make such an exchange, you must work with the annuity or insurance companies involved to transfer the funds directly from one to another. Ensure that both companies involved are aware that you want to make a 1035 exchange. If you cash out the policy and immediately buy another one, it likely will not count in the eyes of the IRS as a 1035 exchange. Note that depending on the circumstances, you may be charged fees by the companies involved for the transaction.
You also must generally replace one policy or annuity with the same type of deal, though some exceptions do apply. You also generally can't change whose name the contract is issued in, which means you can't replace a policy for yourself for one for your spouse or another relative. Make sure the exchange you wish to make is permitted under the rules, or you may face an unwanted tax bill. Consult the IRS, an accountant or tax lawyer for help if you're not sure you understand the rules.
Tax Reporting Requirements
Just because your 1035 exchange isn't a taxable transaction doesn't mean you don't need to notify the IRS. In many cases, you will receive a copy of IRS Form 1099-R from the company where you are closing the insurance policy or annuity indicating that you are making a 1035 exchange. You generally should verify the information on the form is correct and include it on your own tax return.
The reporting requirement is sometimes waived if both annuities or insurance policies are issued by the same company. If you don't get a 1099-R and aren't sure if you should receive one, contact your financial institution for help. If you don't get a satisfactory answer, you can contact the IRS for help.
When an Exchange Is Unnecessary
In some cases, you may not wish to make a 1035 exchange. This would usually be the case if your cost basis in the policy or annuity is less than its surrender value, which can be the case especially early on in the life of a policy or annuity.
In that case, simply surrendering the policy or the annuity usually won't generate any taxable income, so there's usually nothing to be gained by doing a tax-free exchange rather than cashing out the policy or annuity and starting a new one.
On the other hand, since the cost basis is transferred to the new policy, you will end up with a higher cost basis in the new policy if you do the 1035 exchange, since you'll actually only be investing the surrender value into the new plan. This may help you later on when you later extract taxable income from the policy or annuity. Additionally, depending on the rules of the companies involved, you may save on fees by doing a 1035 exchange rather than cashing out one plan and signing a contract for a new one.
If you're not sure what is the better deal, carefully study the terms of the plans or consider consulting a financial advisor or even the companies involved.
Similar Rules for Retirement Plans
Similar rules exist for rolling one retirement plan, such as an individual retirement arrangement (IRA), 401(k) or 403(b) plan into another. These plans are considered tax-deferred, meaning that you usually do not pay tax on the money you put into them until you withdraw the funds, typically at retirement time. If you take money out early, generally before age 59 1/2, you get charged an additional tax penalty.
If you leave an employer and want to move your plan or wish to switch IRA providers, you would therefore be penalized if you move the funds to a new provider without special provisions. Therefore, the tax law allows you to transfer the funds from one plan to another qualifying one directly without any tax or penalty. Work with the companies involved to do the transfer without any tax surprises.
You can also take possession of the funds from a retirement plan for, typically, up to 60 days, then deposit them into another plan without facing a lasting tax penalty. You may have to pay a withholding tax, however, and get the funds back when you file your tax return. If you don't move the money within the 60 day period, you will face a penalty and tax on your funds unless a special exemption applies. Moving the money directly is generally the safer route.
Special rules apply to Roth IRA plans, where you do pay tax on money you put into the plan at the time you earn it, with earnings growing tax-free.
Steven Melendez is an independent journalist with a background in technology and business. He has written for a variety of business publications including Fast Company, the Wall Street Journal, Innovation Leader and Ad Age. He was awarded the Knight Foundation scholarship to Northwestern University's Medill School of Journalism.