Are you looking to swap your old life insurance policy for a newer one? You may want better annuity terms for your retirement. When you know what is not allowable in a 1035 exchange, you can make smarter financial decisions. This is especially true when managing life insurance and annuity products.
While a 1035 exchange allows policyholders to swap one insurance product for another without triggering taxes, not all exchanges are allowed. Simply making the wrong move can lead to unexpected tax penalties and other complications. This guide will explain what you need to know about what’s not allowable in a 1035 exchange.
What Is a 1035 Exchange?
If you’re unsure what a 1035 exchange is, this will make it simple to understand. A 1035 exchange is a tax-free swap of an insurance policy or annuity product for another. This type of exchange gets its name from Section 1035 of the Internal Revenue Code. It allows policyholders to replace an older insurance product with a new one without paying any capital gains tax from the original contract.
If your looking to upgrade your existing annuity contracts or select a better life insurance policy, this option can be beneficial. You can upgrade or adjust financial products without taking a massive a tax hit.
1035 exchange Rules You Should Know
As with any financial process there are some guidelines you must adhere to. These are some 1035 exchange rules you should know before you make and rash decisions.
1. 1035 Exchanges Apply to Specific Types of Property
There are two types of exchanges that allow the exchange of property while deferring capital gains taxes:
- 1031 exchange
- 1035 exchange
It’s easy to get confused between the two.
The former was designed for real estate transactions. This means you wouldn’t use a 1035 for real estate exchanges. By law, it’s not allowable in a 1035 exchange. A 1035 exchange was made specifically for a few types of products, including:
- life insurance policies
- annuities
- endowment contracts
2. Exchanges Must Be Made to Like-Kind Property (with Some Exceptions)
The primary rule is that the exchange must involve products that are similar in nature. For instance, a life insurance for life insurance 1035 exchange is allowed because they are the same kind of vehicle.
You can see the same when swapping one annuity for another annuity. This helps maintain the tax-deferred status of the investments. Switching between two different kinds of vehicles is not allowable in a 1035 exchange. So you can’t make a 1035 annuity to life insurance exchange.
However there are exceptions to this 1035 exchange rule. Exchanges can be made between:
- a life insurance policy to a non-qualified annuity
- a life insurance policy to a long-term care insurance
- a life insurance policy to an endowment
- a non-qualified annuity to a long-term care insurance
- an endowment to a long-term care insurance
- an endowment to a non-qualified annuity
These exceptions can be tricky to navigate because while you can’t make a 1035 annuity to life insurance exchange, you can make one from a life insurance policy to a non-qualified annuity. It’s always best to seek assistance from a financial professional to navigate these 1035 exchange rules.
3. The Owner Must Be the Same for both Contracts
The same person or entity must own both the old and new contracts. Transferring ownership of the financial product from one person to another is not allowed in a 1035 exchange. Ownership must remain the same throughout the entire exchange, and the new policy should have benefits similar to the old one.
These 1035 change rules ensure the policyholder's benefits and obligations remain consistent, making the exchange fair and straightforward. For example, a 1035 life insurance exchange would require you to own the old and new policies. A change in ownership would disqualify the exchange from its tax-free status, so keep this in mind.
4. Institutions Handle This Directly
Exchanging a policy for cash or taking withdrawals is not allowable in a 1035 exchange. Any cash taken out could be seen as income and trigger taxes on any gains. The transaction must also be a direct swap from one institution to another institution.
Some partial exchanges may be accepted with annuities but be sure to consult with a financial advisor before you make a switch. You must consider capital gain taxes and surrender charges. A 1035 exchange is of little value if the surrender charges on your contract override the gains made.
What Is a Non-Qualified 1035 Exchange?
A non-qualified 1035 exchange refers to the tax-free exchange of non-qualified annuities or life insurance policies not held within a tax-advantaged retirement account, like an IRA or 401’. “Non-qualified,” in this instance, means the funds in the annuity or insurance policy were contributed with after-tax dollars. This is unlike qualified accounts, where contributions are made with pre-tax dollars.
What Are Possible Disadvantages of a 1035 Exchange?
These are some disadvantages of a 1035 exchange:
- Exchanging policies may trigger surrender charges, which reduce the value transferred to the new contract. The new policy often starts a new surrender charge schedule, so carefully read the terms of your contract.
- You may lose valuable features from the old policy, like guaranteed rates or special riders.
- Unexpected costs can come from unexpected fees if you aren’t up-to-date on the contract terms. Partial exchanges can have different tax consequences if not handled correctly, leading to unexpected taxes.
- Changes in contract terms may affect how the new contract fits into your overall estate and financial planning strategies.
Make the Right Moves for Your End Game
Work with the team at Asset Preservation Wealth and Tax to choose suitable policies and financial vehicles for you. Our experts assess your goals and objectives to achieve short and long-term needs. Our holistic approach considers everything from taxes to estate planning so you can get a big-picture approach to your financial decisions. Leave no stone unturned with our professionals by your side.
Plan your future with Asset Preservation!
Stewart Willis is the founder and president of Asset Preservation Wealth & Tax, a financial planning firm in Phoenix, Arizona. Investment advisory services offered through Foundations Investment Advisors, LLC, an SEC registered investment adviser.
A Roth conversion may not be suitable for your situation. The primary goal in converting retirement assets into a Roth IRA is to reduce the future tax liability on the distributions you take in retirement, or on the distributions of your beneficiaries. The information provided is to help you determine whether or not a Roth IRA conversion may be appropriate for your particular circumstances. Please review your retirement savings, tax, and legacy planning strategies with your legal/tax advisor to be sure a Roth IRA conversion fits into your planning strategies.
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