1035 Exchange

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21 Aug, 2024

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1035 exchange is a tax law through which an individual can swap or exchange their insurance product with another financial product. It is a provision in the Internal Revenue Service (IRS) code. The prime aim of this code is to let the policyholder recognize the gains in other policies and transfer funds without paying taxes.

Section 1035 exchange is an alternative to the replacement transaction. It allows individuals to switch from one policy to another. As a result, funds get transferred smoothly with no tax levied. However, the policyholder might have to pay a surrender fee and high premiums for this exchange.

What Is 1035 Exchange?

1035 exchange allows individuals to switch to another policy without incurring any taxable amount during the sale. However, policyholders can swap only insurance and annuities in this exchange.
The Internal Revenue Code (IRC) governs this exchange, whereas Internal Revenue Service (IRS) controls the 1031 exchange.
Most policyholders switch because of the gain they will receive from other policies. Also, no sales tax applies, but the time limit is 180 days.
It involves high premiums and surrender fees. Individuals cannot use this exchange for 401(k)s and IRAs (Individual Retirement Accounts).

How Does A 1035 Exchange Work?

1035 exchange allows policyholders to switch from one policy to another without incurring taxes. Moreover, it ensures flexible transfer of invested annuity to any other kind. Besides that, the insurer does not levy any taxes during this transaction. In this approach, they can swap out old, ineffective products for more modern ones with more alluring features, such as better investment opportunities and fewer rules. In addition, the law permits exchanges into long-term care products according to the 2006 Pension Protection Act.

A few investment products like long-term care, insurance, and annuity qualify. For example, a person can use this provision to exchange life insurance for another life insurance policy. Although some regulations may differ depending on the company, full and partial 1035 exchanges are allowed. Beneficiaries must meet the IRS requirements for a 1035 exchange between items within the same company to be exempt from tax reporting.

The Internal Revenue Code proposed this exchange under section 1035 exchange. However, there are quite a few exceptions to this rule. The contract owner or policy must fulfill additional requirements to be eligible for a Section 1035 exchange. Let us look at them:

Exchanging life insurance with another life insurance policy.
Life insurance policy for a non-qualified annuity.
Non-qualified annuity with another non-qualified annuity.
Annuity with long-care insurance.
Endowment insurance for the annuity.

However, a person cannot switch a non-qualified annuity for a qualified annuity. Therefore, per the 1035 exchange rules, a policyholder can exchange if they qualify for the above criteria. In addition, a 1035 exchange time limit of 180 days applies to avail of this tax avoidance. Besides, it does attract some surrender charges on the transaction.

1035 Exchange Form

While filling out the 1035 exchange form, an individual must fill in certain details. They are the following:

Details of the type of policy, like a fixed annuity, variable annuity, and life insurance.
Address, name of the institution, and the policyholder.
Name of the annuitant, beneficiary, and others.
Type of Exchange: partial or full.
Other details include transfer proceeds, date of transfers, and phone number.

Difference Between A 1035 Exchange And Transfer

Although 1035 exchange and transfer have the same meaning, they differ hugely. For example, an individual can transfer assets, funds, or rights to another person. However, the 1035 exchange rules allow policyholders to exchange one policy for another. Besides, policyholders get a 1035 exchange time limit of 180 days to avoid taxes. However, there is no such tax limit on transfers.

Parameters	1035 Exchange	Transfer
Meaning	Exchange of one policy with another.	A shift of assets, money, or rights from one place to another.
Regulated By	Internal Revenue Code	Major financial institutions of a particular country.
Time limit	No taxes applicable for 180 days	Non-taxable sale

1031 vs 1035 Exchange

Although the 1035 and 1031 exchanges involve the swapping of investment products, they differ slightly. The former focuses only on the exchange of insurance and annuities, and the latter targets property sales.

For example, a person might use the 1031 exchange to sell one property and buy another property. In this way, the buyer can cut capital losses during the sale. However, the transfer taking place must have similar characteristics.

Metrics	1031	1035 Exchange
Meaning	Swapping one real estate property with another.	Exchanging one insurance or annuity policy with another.
Purpose	Helps in deferring capital gains or losses during the sale.	Helps in tax avoidance for 180 days.
Regulated by	Internal Revenue Service (IRS)	Internal Revenue Code
Target	Real estate property	Insurance and Annuities

Pros And Cons

These policies can usually compare other policies, choose the best, and swap. Individuals can avail of tax avoidance within 180 days from the exchange date. Also, qualified retirees cannot use this exchange to switch to another policy. Some other pros and cons are the following -

Pros	Cons
Easy switch to another policy	It involves certain surrender fees.
No taxes applicable	High premiums
Allows switching to another insurance company	Cannot exchange qualified retirement plans (like 401(k)s or IRAs)

Frequently Asked Questions (FAQs)

How often can you do a 1035 exchange?

There is no limit on the number of swaps in this exchange. Therefore, an individual can exchange multiple contracts for one policy. However, one cannot exchange a single contract multiple time.

Can a person use a 1035 exchange in an inherited annuity?

Individuals can use this exchange to directly transfer funds from an inherited annuity to a new policy. For example, Mr. John can transfer some invested amount from his inherited annuity to a newly formed annuity.

How to report a 1035 exchange on form 1040?

For reporting an exchange to another company, a policyholder has to follow certain steps. First, they have to file the 1099-R report to another insurance policy. Although there are no taxes applicable, this serves as a registry record. Then, file the exchange, fill in the details in Form 1040, and submit it on the IRS portal.

Can a person do a partial 1035 exchange?

No, an individual cannot perform a partial exchange. However, they can do it while switching from a deferred annuity to a new or existing policy. And the amount will be tax-free if the policy is for at least 10 years.