A 1035 annuity exchange is a rule under Section 1035 of the Internal Revenue Code that allows for a tax-free exchange of a life insurance or annuity policy for a different annuity contract that is better suited to an investor’s needs.
What if you purchase an annuity and later find that a different type of annuity is better for you? Surrendering your annuity early can be costly. On top of a potential surrender charge of as much as 15 percent, you could also be hit with a 10 percent tax penalty if you’re not 59 ½ years old yet. Plus, you will owe income tax on any profit — or annual return — you’ve made on the annuity.
But you can avoid at least the tax consequences with a 1035 exchange. If you purchase an annuity and later find an annuity with better terms, there is a provision in the law that permits exchanging one annuity for another, as long as the person who holds the contract doesn’t change.
Federal Tax Law Applies to Exchanges
Section 1035 of the Internal Revenue Code, which also applies to life insurance policy exchanges, governs annuity exchanges. Named for the section that regulates them, Section 1035 exchanges also allow the exchange of a life insurance policy for an annuity — but not the exchange of an annuity for a life insurance policy.
There are important restrictions on 1035 exchanges. You may use it only to roll one annuity over into another annuity. If you try to cash out your annuity and use the money to purchase another annuity, the law won’t cover that exchange, and you will not be spared the tax consequences.
In 2013, the IRS ruled that people who inherit annuities may also qualify for a 1035 exchange, as long as they follow all the other rules for inherited annuities. For example, nonqualified annuities can’t be exchanged for qualified annuities.
The IRS allows the exchange of multiple annuity contracts for a single contract, one contract for multiple contracts, and a portion of an annuity for an alternate annuity.
According to the IRS chief counsel’s 2003 Internal Revenue Bulletin, “the legislative history of § 1035 states that exchange treatment is appropriate for ‘individuals who have merely exchanged one insurance policy for another better suited to their needs and who have not actually realized gain.’”
The exchange treatment includes the provision that “the exchange, without recognition of gain or loss, of an annuity contract for another annuity contract under § 1035(a)(3) is limited to cases where the same person or persons are the obligee or obligees under the contract received in the exchange as under the original contract.”
Put simply, if you follow the rules outlined in Section 1035, you can take advantage of the tax benefits and the carryover of the cost basis of your existing annuity to the new contract. The cost basis is the principal amount of your annuity — the original purchase price of your contract, either as a lump sum or as regular premium payments.
For example, you purchased your original annuity with $100,000, you retain the $100,000 principal in the new contract, regardless of the current value of the original annuity.
And if you used after-tax dollars to buy your annuity, you would not have to pay taxes on any of the $100,000 principal that was transferred to your new contract when you withdraw the funds.
Reasons for and Against Exchanging Your Annuity
According to the Financial Industry Regulatory Authority, legitimate reasons for making a 1035 exchange include:
- A new annuity contract may come with a premium, or bonus, toward the value of your contract, ranging from 1 to 5 percent of purchase payments.
- New features are becoming available, particularly with variable annuities. For example, the contracts may cost less or the death and life benefits may be better.
Other reasons to exchange your annuity include:
- You decide you would rather have a fixed annuity instead of your variable annuity.
- A new annuity might offer better investment options and lower costs.
- The company holding the current annuity contract isn’t as strong financially as it was before.
- Your fixed annuity contract has a lower interest rate than a newer one.
But FINRA (Financial Industry Regulatory Authority) warns that 1035 exchanges may not be a good idea for you. Often, bonuses or premiums can be offset by other charges added to the contract. Also, the new contract could extend the surrender period, which may have expired or be near expiration with the old annuity contract.
The new contract may also come with higher annual fees, and you might not need the extra features of the new contract, which can be expensive. You should check your broker’s commissions, which may be his or her incentive to sell you the new annuity even if it’s not best for you.
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Is a Section 1035 Exchange Right for You?
In order to determine if the exchange meets your needs, read all the documents associated with the transaction.
FINRA recommends asking the following questions of the person recommending it:
- What is my total cost?
- What does the change in the surrender period or other terms mean for me?
- What are the new features offered? Why do I need or want them?
- How are those features worth the increased cost?
- How much will your commission be?
How Do I Make a 1035 Exchange?
First off, don’t cash out your old annuity with the idea of using the proceeds to buy a new annuity. Doing so would disqualify the transaction from 1035 tax protection. The IRS would recognize the cash you received from your old annuity as realized income, or income that has been converted into cash flow, not a transfer. Realized income is taxable income, and therefore it is not eligible for exchange treatment.
Instead, contact both annuity companies — your present company and the company offering the alternate contract.
First, contact the provider of the annuity you want to purchase. They’ll send you the paperwork for the exchange, which may include a letter to your current annuity company, an application for the new annuity, and compliance forms.
Once you have signed and submitted the appropriate paperwork, the two companies will handle the transaction moving forward.