INVESTMENT READ TIME: 5-6 MIN
Understanding 1035 Exchanges for Life Insurance and Annuities
Many U.S. adults approach retirement with existing life insurance policies or annuity contracts purchased years—or even decades—earlier. Over time, personal circumstances, tax considerations, and product features may change. In some situations, policyholders may wish to replace one insurance or annuity contract with another without triggering an immediate taxable event. One provision of the U.S. tax code that may allow this is known as a 1035 exchange.
What Is a 1035 Exchange?
A 1035 exchange refers to Section 1035 of the Internal Revenue Code. This rule allows certain life insurance policies, annuities, and similar contracts to be exchanged for new contracts without treating the transaction as a taxable surrender or sale, provided specific requirements are met.
According to industry data, Americans collectively hold life insurance policies with a total face value measured in the trillions of dollars. As policyholders age and approach retirement, some discover that an existing policy or annuity may no longer align with their current financial priorities. A 1035 exchange is designed to offer a way to reposition an insurance or annuity contract while deferring income taxes on accumulated gains.
It is important to note that not all exchanges qualify. The transaction must follow IRS rules precisely, or it may result in unintended tax consequences.
Types of Exchanges Allowed Under Section 1035
Under current tax law, a 1035 exchange is generally limited to exchanges involving the same policy or contract owner and specific product types. Common examples include:
Life Insurance to Life Insurance
A life insurance policy may be exchanged for another life insurance policy. In certain cases, it may also be exchanged for an endowment contract or a qualified long-term care insurance contract.
Annuity to Annuity
An annuity contract may be exchanged for another annuity contract. This is often considered when contract features, costs, or payout options differ from the original annuity.
Life Insurance to Annuity (Limited Cases)
Some life insurance policies may be exchanged for annuities, though the reverse—annuity to life insurance—is generally not permitted under 1035 rules.
Because eligibility depends on contract details and tax regulations, consulting a qualified tax professional is typically recommended before initiating an exchange.
Why Policyholders Consider a 1035 Exchange
A 1035 exchange may offer flexibility for individuals whose needs have evolved. Reasons policyholders sometimes explore an exchange include:
- Changes in retirement income planning goals
- A desire to modify death benefit structures
- Differences in contract costs or available features
- Shifts in risk tolerance or time horizon
While a newer contract may differ in structure or features, it is not automatically more suitable for every individual. Each exchange involves trade-offs that should be evaluated carefully.
Partial 1035 Exchanges
In some situations, a policyholder may complete a partial 1035 exchange, moving only a portion of an annuity contract’s value into a new annuity. Partial exchanges involve additional tax considerations. If funds are later withdrawn, a portion of the withdrawal may be treated as taxable ordinary income.
Due to the complexity of partial exchanges, tax guidance is especially important to help avoid unexpected tax results.
Key Considerations and Risks
Life Insurance Considerations
The cost and availability of life insurance depend on factors such as age, health, policy type, and coverage amount. Life insurance policies include expenses, such as mortality charges and administrative fees. Surrendering a policy may result in surrender charges and possible tax consequences. Individuals considering an exchange may wish to confirm ongoing insurability before proceeding.
Any guarantees associated with a life insurance policy depend on the claims-paying ability of the issuing insurance company.
Annuity Considerations
Annuities include contract limitations, fees, and charges, which may include administrative fees, investment management expenses, mortality and expense risk charges, and optional rider costs. Many annuities impose surrender charges if funds are withdrawn within certain time periods.
Withdrawals from annuities are generally taxed as ordinary income. Withdrawals taken before age 59½ may be subject to a 10% federal income tax penalty unless an exception applies. Annuities are not insured by the FDIC or any government agency, and guarantees rely on the issuing insurer’s financial strength.
Variable Annuities
Variable annuities are offered by prospectus, which describes investment objectives, risks, charges, and expenses. Subaccounts fluctuate with market conditions and may be worth more or less than the amount invested. Reading the prospectus carefully is encouraged before purchasing or exchanging a variable annuity.
The Importance of Professional Guidance
A 1035 exchange involves detailed tax rules and insurance contract provisions. While the exchange itself may defer taxes, it does not eliminate them entirely. A tax professional and a qualified financial professional can help evaluate whether an exchange aligns with broader retirement planning considerations.
Understanding both the benefits and limitations of a 1035 exchange can help individuals make informed, tax-aware decisions as they approach retirement.
