What is a 1035 Exchange?

Most readers are well aware of my bias against annuities. But what about  annuities you already own? A technique called a “1035 Exchange” may be just what you’re looking for. But don’t rush into your broker or insurance salesman’s office before reading this article.

A “section 1035 (ten-thirty-five) exchange” refers to the part of the Internal Revenue Code that allows owners to replace a life insurance or annuity policy while delaying any taxes that would have been due had you cashed out. That may sound just peachy, but do your homework if your insurance agent suggests it.

For example, “bonus credits” are often used as an enticement to purchase or exchange or a variable annuity. These contracts promise to add bonus money to your contract value based upon a specified percentage (typically 1% to 5%) of purchase payments. But you don’t get them for free. Frequently, insurers will pay for these credits with higher charges or by changing the surrender period.

What to find out before using a 1035 exchange:

  • Bonus or “premium” credits: ask the salesman if the bonus is worth more than any increased charges you will pay.
  • Withdrawals: under some annuity contracts the insurer will take back all bonus payments made to you within the prior year or some other specified period.
  • Expired contract provisions: if your surrender charges are at or near expiration, will you be locked into a new surrender charge period when you exchange?
  • Surrender charges: will the new surrender period be even longer than the one attached to your current annuity? Will the charges be higher?
  • Mortality, expense risk, and other charges (such as annual fees): will they be higher in the new annuity? Even small increases can make a big difference in the long term.
  • New features: are you paying for costly new features that you really don’t need?
  • Commission: will the salesman be paid a commission on the exchange? If so, ask how much.

Some instances when you may benefit from a 1035 exchange:

  • Outdated mortality tables: Americans are living longer. If your current policy was issued using outdated mortality tables, you may reduce your mortality costs under a policy using current tables.
  • Underperforming policy: a policy issued when interest rates were 9% that is earning only 4% will require more premium payments than originally projected in order to make up for that shortfall, perhaps over many years. Exchanging into a policy based upon current low rates of return provides a greater degree of certainty about future payments.
  • If you want to cash in a whole life policy with a loss. You cannot deduct a loss on cashing in a life insurance policy but you may be able to exchange for an annuity with a low-load provider such as Jefferson National Monument and use the loss to reduce income from the annuity.

Do not sign any exchange form or agree to exchange or purchase an annuity until you study all of the options carefully, have all of your questions answered, and are satisfied that the exchange is better than keeping your current contract.

Here’s another idea – what if you could:

  • Convert your annuity into tax-free status without paying a cent of tax, and
  • Buy long-term care insurance (“LTCI”) without writing a check?

It’s possible. Rules from the Pension Protection Act of 2006 that became effective in 2010, permit annuity holders to pay for long-term care insurance with a life insurance policy or annuity, using a “partial 1035 exchange”, as explained in IRS Revenue Procedure 2011-38. In doing so, you convert taxable gains into a tax-free LTCI. Since LTCI premiums are deductible, be sure to check with your financial advisor to determine whether a 1035 exchange is appropriate.

One thought on “What is a 1035 Exchange?

  1. I appreciate the information on a 1035 Exchange. I agree that it is important to find out if doing a 1035 exchange is actually really any good for you, I have heard a lot about others successfully exchanging their 1035’s but I don’t think it is for everyone. My brother is debating on doing this for himself, I will be sure to share this with him.


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