Posted by Fletcher Accounting and Tax Service Inc.

What is 1035 annuity exchange?

What is 1035 annuity exchange?

The Internal Revenue Code has a new rule under Section 1035 which is called the 1035 annuity exchange. Through this, tax-free exchange of annuity policy or life insurance for a better one that better suits the investor's needs. 

What if you find out after purchasing an annuity that a different type is better for you? It might cost a lot if you’ll surrender your annuity early. If you are not 59 ½ years old yet, you could he face a 10 percent tax penalty on top of a potential surrender charge. Plus, on any profit you've made an annuity, you will owe income tax or annual return. 

But, with the 1035 tax exchange, you can avoid at least the tax consequences. There is a provision in the law that permits exchanging one annuity to the other if you purchase an annuity but later find an annuity with better terms. But as long as the handler of the contract does not change. 

Federal Law Applies to Tax Exchanges

The Internal Revenue Code Section 1035 governs annuity exchanges and also applies to life insurance policy exchanges. Named for the section that regulates them, Section 1035 does not allow the change of annuity for a life insurance policy but it allows the exchange of life insurance to the annuity. 

On 1035 exchanges, there are a lot of important restrictions to consider. To roll one annuity over into another annuity is the only time when you may use it. The law will not cover the exchange if you want to cash out your annuity and purchase a new one using that money. And, you will not be spared with the tax consequences. 

The IRS ruled in 2013 that as long as people who inherit annuities will follow the rules for inherited annuities then they may also qualify for a 1035 exchange. For example, qualified annuities can't be exchanged for nonqualified annuities. 

The exchange of multiple annuity contracts, a portion of annuity for an alternate annuity, and one contract to multiple contracts are allowed by the IRS. 

The legislative history of § 1035 states that individuals who have merely exchanged one insurance policy for another better suited to their needs and who have not actually realized that are appropriate for the exchange treatment according to the IRS chief counsel’s 2003 Internal Revenue Bulletin. 

The provision that says without the recognition of gain or loss of the exchange of an annuity contract for another annuity contract as stated in § 1035(a) (3) is limited to instances where the oblige or obliges are the same person or persons under the contract received in the exchange as stated on the original contract.

You can carry over the cost basis of your existing annuity to the new contract, and take advantage of the tax benefits if you simply follow the rules outlined in Section 1035. Either a lump sum or as regular payments, the original purchase price of your contract is the cost basis principal amount of your annuity. 

So for example, if you purchase your original annuity with $100,000, regardless of the current value of the original annuity, you will retain the $100,000 principal in the new contract. 

You would not need to pay taxes on any of the $100,000 principal that was transferred to your new contracts when you withdraw the funds if you used after-tax dollars to buy your annuity. 

Reasons against exchanging your annuity

Below are the legitimate reason for making a 1035 exchange according to the Financial Industry Regulatory Authority:

  • A bonus, a premium may come with a new annuity contract toward the value of your new contract ranging from 1 to 5 percent of purchase items. 
  • Particularly with variable annuities, new features are becoming available. For example, the death and life benefits may be better and the contracts may cost less. 

Other reasons to consider when you change your annuity:

  • You decide you would rather have a variable annuity instead of a fixed annuity. 
  • Lower costs and better investments might be offered by a new annuity. 
  • Compared to before, the company holding the current annuity contract is not as strong financially. 
  • Your new fixed annuity contract has a lower interest rate. 

But the 1035 exchange might not be a good idea for you FINRA warns. Often, other charges added to the contract can offset bonuses or premiums. Also, the surrender period which may be near expiration or may have expired with the old annuity contract can be extended by the new contract. 

Higher annual fees may also come with the new contract and you need to check the extra features the contract might have. You have to think twice first and double-check to refrain yourself in a worse situation. 

Fletcher Accounting and Tax Service Inc.
Contact This Member