1035 Exchange Rules: An Overview

1035 Exchange Rules

The IRS provides the detailed regulations governing 1035 exchanges in Section 1035 of the tax code. There are several important rules to keep in mind when helping a client decide whether a 1035 exchange makes sense for their situation:

Policyholders can exchange an insurance policy for another life insurance policy, an annuity contract, a long-term care insurance policy, or endowment contracts. They can exchange an annuity for another annuity, but not for life insurance.
Partial exchanges are allowed, although a 1035 exchange can also cover the full policy.
The policyholder must repay any outstanding loans before the exchange takes place.
The owner of the policy cannot take possession of the proceeds during the transfer. Instead, they must roll directly into the purchase of the new life insurance, long-term care insurance policy, or annuity.
After the transfer, the original basis for the policy remains, even if the value of that basis is higher than the current cash value of the policy.
Annuities held in a qualified account, such as an IRA, are ineligible for a 1035 exchange, since they’re already not taxable.

Conclusion

A 1035 exchange can be a helpful tool for clients who have an insurance policy or annuity that no longer adequately serves their needs. But it’s not the best move for everyone. Contract limitations remain, so holders may still face surrender charges associated with giving up their original policy.

If a client does go through with a 1035 exchange, they typically still need to report the transaction on their taxes using a 1099-R form.

They may need to qualify for a new insurance policy based on their age, health and other factors. By discussing these issues with clients, you can help them decide whether pursuing a 1035 exchange is the best solution for them.

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