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Couple considers a 1035 exchangeAnnuities can be a useful tool for retirement planning if you’re looking for a way to create a guaranteed income stream. You may also choose to receive an annuity rather than a lump sum payment if you’re on the winning end of a lottery payout. Along with life insurance policies, annuities can be important parts of a well-rounded estate plan. But if at some point you decide you need to swap one annuity or life insurance policy for another, you can do so – without incurring a tax – through a 1035 exchange. If you want hands-on guidance navigating this maneuver, considering linking up with an expert financial advisor.

1035 Exchange, Definition

A 1035 exchange is a legal way to exchange one insurance policy, annuity, endowment or long-term care product of like kind without triggering tax on any investment gains associated with the original contract. The IRS allows these exchanges under Section 1035 of the Internal Revenue Code.

That doesn’t mean the exchange is completely tax-free, however. If annuity payments are taxable, then the tax is simply deferred until you begin receiving payments from it. A 1035 exchange can be a useful tax loophole if you want to use an annuity or life insurance policy to plan your estate but decide at some point that the one you have no longer fits your needs.

How a 1035 Exchange Works

A 1035 exchange may sound complicated, but it’s actually a simple way to make sure that you have the right annuity or life insurance product that fits your needs.

Essentially, if you have an annuity or life insurance policy you would replace either one with a new annuity contract or insurance policy, respectively. In the case of an annuity, the annuitant or person receiving payments from the annuity (which would be you) must remain the same. With a life insurance exchange, you would still be the covered person but you could change the beneficiary on the policy.

When you make the exchange, no taxes are incurred on any investment gains associated with swapping out one contract for another. But there are a couple of rules the IRS requires you to follow:

  • When a 1035 exchange involves life insurance, you must make an even trade in swapping out your old policy for a new one. You can’t cash out the old policy and use the money to buy a new one.
  • 1035 exchanges can only go certain ways. For example, you can exchange life insurance for life insurance or life insurance for a non-qualified annuity. But you can’t exchange a non-qualified annuity for a life insurance policy. Also, life insurance policies and non-qualified annuities may be exchanged for traditional and hybrid qualified long-term care products.

If you were to surrender a life insurance policy without going through a 1035 exchange to replace it with a new policy or an annuity, any gains associated with your original contract would be considered ordinary income. This is something to keep in mind if you have a permanent life insurance policy that allows you to build cash value through investments.

It’s also important to remember that any other exchanges of life insurance, annuities or endowments that don’t fit the IRS rules above would not enjoy tax-advantaged status.

Benefits of Using a 1035 Exchange

Paper umbrella over a paper house and family

The primary advantage of using a 1035 exchange to change your life insurance policy or annuity choices is to avoid triggering taxes on those transactions. There are different scenarios where exchanging policies or annuity contracts might make sense. For example, you may want to do a 1035 exchange if:

  • You need more life insurance coverage than you currently have
  • You want to change the type of life insurance policy you have
  • You’re looking for an annuity contract with lower fees
  • You want to restructure your annuity payments
  • You need a completely different type of annuity

As long as you’re exchanging contracts within the guidelines set by the IRS you wouldn’t have to worry about those events being taxable to you. You may, however, still have to pay a surrender charge to trade one annuity contract or life insurance policy for another.

Surrender charges are essentially a penalty for canceling your contract with the insurance company or annuity provider. These fees vary in terms of how much they are and when you’ll have to pay them. They can be charged as a flat fee or as a percentage of the amount paid into the contract.

It’s possible that your life insurance company or annuity provider may waive any surrender charges if you’re exchanging policies or contracts with the same company. But if you’re moving your policy or contract to a brand-new company, you may have to factor in the surrender cost as part of the process.

What to Consider Before Doing a 1035 Exchange

If you’re thinking of exchanging one life insurance policy or annuity for another, be sure to look at the bigger picture and how it may impact your financial plan.

For example, with a life insurance exchange ask yourself these questions:

  • Will my current health status affect my ability to qualify for a new policy?
  • What’s the waiting period for the new policy before death benefits can be paid?
  • Is it possible that my premiums will increase based on age or health?
  • Are there any outstanding loans on the policy that would need to be repaid before an exchange can be made?
  • Will a new policy offer a better death benefit or additional features, such as accelerated death benefit or long-term care riders?

With an annuity, the questions you might ask are a little different. For instance, you should ask things like:

  • Would a new annuity be more cost-friendly in terms of lower fees?
  • Will the structure of my annuity payments change?
  • Does a new annuity offer the potential for better investment returns?
  • Does an annuity still fit my estate and retirement planning needs?
  • Will I pay a surrender fee to exchange annuities?

Remember, when exchanging life insurance or annuity you have to remain the owner of the policy or contract. If the ownership of either one changes, then the 1035 exchange tax rules no longer apply.

The Bottom Line

Mother and daughter

A 1035 exchange can be a useful tax rule to know about if you have an annuity, life insurance policy, endowment or long-term care product. The 1035 rule lets you exchange one of these for another of like kind without triggering taxes on any investment gains associated with the original contract. Whether it makes sense financially can depend on the other details of your estate plan and retirement strategy. But knowing that this is an option is important if you find that your life insurance policy or annuity no longer aligns with what you need.

Retirement Planning Tips

  • Consider talking to a financial advisor about the tax implications of a 1035 exchange and whether it’s the right move for you. If you don’t have a financial advisor yet, finding one doesn’t have to be complicated. SmartAsset’s financial advisor matching tool can help you connect with professional advisors in your local area in just minutes. If you’re ready, get started now.
  • When comparing annuities, take time to look at the details. That includes not only the annuity’s terms and costs but the quality of the company that’s issuing the annuity. If a company isn’t financially healthy, it’s possible that they may not be able to make your annuity payments when the time comes.

Photo credit: ©iStock.com/kupicoo, ©iStock.com/belchonock, ©iStock.com/FatCamera

Rebecca Lake Rebecca Lake is a retirement, investing and estate planning expert who has been writing about personal finance for a decade. Her expertise in the finance niche also extends to home buying, credit cards, banking and small business. She's worked directly with several major financial and insurance brands, including Citibank, Discover and AIG and her writing has appeared online at U.S. News and World Report, CreditCards.com and Investopedia. Rebecca is a graduate of the University of South Carolina and she also attended Charleston Southern University as a graduate student. Originally from central Virginia, she now lives on the North Carolina coast along with her two children.
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