What to Keep In Mind With a 1035 Annuity Exchange - Tax Professionals Member Article By KLSM CPA Firm PLLC
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What to Keep In Mind With a 1035 Annuity Exchange

What to Keep In Mind With a 1035 Annuity Exchange

This guide will tell you everything you need to know about 1035 exchanges: how they work, the different types, and how to assess whether a 1035 exchange is right for you.


What is a 1035 exchange?

A 1035 exchange lets you use an existing annuity to purchase another annuity policy without creating a taxable event. By following the 1035 exchange rules, you maintain the tax-deferred status of your annuity policy. Policyholders and annuitants will generally need to stay the same to comply with IRS regulations.

1035 exchanges make sense when your existing policy is not optimized for your purposes, if a new policy could provide a greater benefit at the same or lower cost, or if your existing policy is maturing. The policyholder decides whether or not to switch to 1035 after understanding the advantages and disadvantages of their choice in light of the other options available.

Some policies (such as annuities) are irrevocable and therefore cannot be used in a 1035 exchange.

This article outlines the factors to consider when deciding if a 1035 annuity exchange makes sense, provides a step-by-step process for conducting a 1035 exchange, and answers some of the most common questions about a 1035 exchange.


Factors to Consider When Evaluating a 1035 Exchange

Annuity Goals: Why did you purchase an annuity or life insurance policy in the first place? Was it for guaranteed growth? Or did you want to use it for tax deferral? Or to benefit your family after your death? Is the reason you purchased the annuity policy still valid?

Before considering a 1035 exchange, it is important to remember your goals when you purchased the policy and how far your goals are. Doing this first will guide you in determining if a new annuity is right for you, if it solves your problems and which type will be most effective in doing so. A new policy may have better rates, lower costs, have a higher death benefit, be more optimized for your current situation, or offer more investment options.


 

Surrender fees or limitations of existing policies and determining if it's the right time to do the 1035 exchange: The first question to ask is, does your existing annuity have surrender fees? If so, what is the repayment schedule for the next few years?

Most annuities have some sort of surrender charge, at least initially. We recommend that you know the surrender charge schedule because even if your existing policy, for example, pays lower surrender charges than newer products, it may not be wise to make a 1035 exchange, depending on how huge the surrender fee is on the old product, how much better is the rate for the new product, and how high are the redemption rates for the new product (including how long they will remain in effect)?

 

Surrender Fees or Constraints of the New Policy: What will be the new surrender fee with the new policy I'm buying?

You will likely have a longer repayment schedule than the policy you are replacing. You will want to understand this.


Interest/payment rate of the old and new policy: What is the rate difference between the new and old policy? It is recommended that the surrender charge of the forfeited policy be included in this calculation.


Assessments regarding the financial strength of the insurer issuing the old and new policies: This is an important variable with a guaranteed annuity: is the insurer's financial strength rating better or worse with the new policy than with the old one?

 

Tax Implications of a 1035 Exchange

During a 1035 exchange, no income tax is paid on the original policy when transferred to the new policy. If you surrendered the policy without the 1035 exchange, however, the initial capital gain of the policy would be taxed as ordinary income.

The policyholder cannot accept the implied receipt of funds and place them in a new policy. Money should be transferred directly from the existing product owner to the new product owner.

The 1035 exchange also allows the policyholder to keep the basis even if there are no gains to carry forward. For example, if an annuity policy purchased for $100,000 has a present value of $90,000, it can be transferred through a 1035 exchange and has a basis of $100,000.


Life Insurance and Annuity 1035 Exchanges

1035 exchanges must occur between "like-kind" products such as life insurance to life insurance, annuity non-qualifying to annuity non-qualifying, and life insurance to annuity non-qualifying. However, a non-qualified annuity cannot be exchanged for a life insurance policy.

Life insurance can be exchanged for another life insurance policy or an annuity. An annuity can only be exchanged for an annuity.

 

1035 Exchange rate

There are no specific rates for a 1035 exchange. But there may be exit fees from the existing annuity in the form of surrender fees which are generally not waived for 1035 exchanges. If the exchange is within the same company, rates may not apply. It is worth contacting your existing insurer to see if this is an option. Generally, 1035 exchanges between products within the same insurer do not need to be reported to the IRS.

All 1035 exchanges have no surrender fees. For example, if a 5-year fixed rate annuity policy is in the renewal window, or if the policy is over 10 years old, it will generally not have surrender charges associated with the 1035 exchange.

 

Steps of the 1035 Process 

Here is the procedure to exchange an annuity:

  • Decide if your existing 1035 policy makes sense.

  • Choose a policy to 1035 into.

  • Contact the insurer that holds your current policy to understand the document requirements.

  • Complete and submit the New Annuity Application, including the 1035 transfer request form.

  • New contract issued.

 

Different Types of 1035 Annuity Exchanges

The 1035 process will vary depending on the type of annuity you are exchanging from and into.


Use proceeds from a fixed indexed annuity

You can convert your fixed index annuity (FIA) to an income annuity, fixed annuity, variable annuity, or another fixed index annuity. There are many factors to consider when choosing between these products, and you should speak with an authorized representative experienced in these transactions. Surrender fees may be associated with the exchange of contracts.

If you are looking for an annuity, we recommend comparing it specifically to the fixed index annuity pilot income (if you have one) to understand how much income you will get with the fixed index annuity versus how much income you will get from the income annuity.

If you're looking for a fixed annuity, you'll want to make sure you're getting a higher guaranteed rate of return than your current policy, and if you're doing 1035 with surrender charges, you'll be even better off.


Use of proceeds from a variable annuity

You can convert your variable annuity (VA) to an income annuity, a fixed annuity, a fixed indexed annuity, or another variable annuity. There are many factors to consider when choosing between these products, and you should speak with an authorized representative experienced in these transactions. Surrender fees may be associated with the exchange of contracts.

If you are looking for an annuity, you want to compare it to an income rider (if you have one) to determine how much income you will get from VA versus what you will get from annuity income.

If you're looking for a fixed annuity, you'll want to make sure you're getting a higher guaranteed rate of return than your current policy, and if you're doing 1035 with surrender charges, you'll be even better off.


Use of proceeds from a Non-Maturing Traditional Fixed Annuity

You will be charged a surrender fee if the fixed annuity is not about to mature. Be sure to compare the amount of money you will have at the end of your current policy with the amount net of surrender charges applied at a potentially higher rate under the new policy. Unless rates have gone up since you bought the policy, it makes sense to wait before it expires before buying a new one.


Use of proceeds from a Maturing Traditional Fixed Annuity

If the fixed annuity is about to mature, you have the option of making 1035, withdrawing your money, or renewing it. If you don't need the capital and want to keep your money growing, compare your 1035 into a new fixed annuity to a renewal with your current provider.


Here is the basic process for 1035 with a maturing policy:

1. Know when the policy matures: It is important to know exactly when it will mature.

2. Find out how long you must tell the carrier you are doing something.

3. Know your renewal rate and term: Some assign you a monthly renewal rate (usually very low) until the policy automatically renews.

4. Prepare a month in advance: Your company must have the necessary documentation to file 1035 within a certain time after it expires. In most cases, the interest rate will drop during this time, which means that if you haven't started the process yet, you could be giving up some money.


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