how a 1035 exchange works
a 1035 exchange allows individuals to transfer life insurance annuities and endowments to a similar vehicle tax free these transfers must be between similar products such as life insurance for life insurance or a non qualified annuity for a non qualified annuity the 2006 pension protection act ppa modified irc section 1035 to include exchanges from life insurance policies and non qualified annuities into traditional and hybrid qualified long term care products 1under a 1035 exchange the contract or policy owner cannot take the funds and buy a new policy the money must be transferred directly 2 the annuitant or policyholder must also remain the same for example a 1035 exchange from an annuity owned by joe sample cannot be exchanged for an annuity owned by jane sample or a joint annuity owned by joe and jane sample 3 the exchange must be reported on the individual s annual tax return using form 1099 r 4a life insurance policy can be exchanged for a non qualified annuity but a non qualified annuity cannot be exchanged for a life insurance policy 3costs and benefitsthe primary benefit of a section 1035 exchange is that it lets the contract or policy owner trade one product for another without tax consequences outdated and underperforming products can be switched to newer products with more attractive features such as better investment options and less restrictive provisions despite the tax benefits 1035 exchanges do not absolve contract owners of their obligations under the original contract for example insurance companies typically don t waive surrender charges for 1035 exchanges however fees may be waived if the owner exchanges one product for another within the same company product owners should compare the features of each policy or contract subject to the exchange and conduct a cost benefit analysis the new policy should match an individual s investment goals owners should consider the administrative fees and transaction charges such as withdrawal or surrender charges the financial institution for the new policy must be assessed on how well it manages its assets liabilities and shareholder obligations if any the tax treatment differs for partial exchanges in that a portion of the cost basis is allocated to the new product rather than all of it 5example of a 1035 exchangejoe sample invested 100 000 the cost basis in a non qualified annuity joe took no loans or withdrawals so the value remains unaffected because of poor investment performance the value of the annuity dropped to 75 000 dissatisfied joe transfers his funds into another annuity with another company in this scenario the original contract s cost basis of 100 000 becomes the new contract s basis although just 75 000 was transferred 5