What Is a 1035 Exchange?

As you go through your life, it’s not uncommon for your priorities to change. Sometimes, people who have accumulated significant value in permanent life insurance policies find that as they get older, financial options like an income annuity are more appealing. The rub is that if you were to surrender your permanent life insurance policy and use the proceeds to get an annuity, you may also face a hefty tax bill on any gain you’ve had above the basis that you paid into your policy. Enter the 1035 exchange.

A section of the tax code (1035) allows you to trade certain types of life insurance policies or endowments for similar ones, typically without incurring taxes. To avoid tax penalties, though, you’ll need to follow IRS guidelines around what exchanges are allowed and how the exchange can take place. We’ll help you understand what a 1035 is, how it works, guidelines you’ll need to follow, and things to keep in mind when considering an exchange.

What is a 1035 exchange?

With a 1035 exchange, the IRS allows you to trade in an existing annuity contract, life insurance policy or endowment for another annuity contract, life insurance policy or endowment of like-kind without having to pay additional taxes (however, you could still be subject to surrender fees or tax deferments from your old policy). The benefit of doing a 1035 exchange is that you can trade in an old policy for a newer one with better features, provided that you follow the IRS guidelines for the transfer and it is a like-kind exchange. If you were to attempt to switch without doing a 1035 exchange, any gains from your original contract would be counted as ordinary income and taxed as such.

What qualifies as a like-kind exchange?

Generally speaking, 1035 exchanges must occur between products that are of the same kind. Life insurance policies can be exchanged for other life insurance policies, most types of annuities can be exchanged for other annuities (although there are a few limitations), endowments can be exchanged for other endowments, and so on. One exception to this general rule is that permanent life insurance policies can be exchanged for non-qualified annuities, but non-qualified annuities cannot be exchanged for permanent life insurance policies. Here are the like-kind exchanges allowed under a 1035 exchange:

What is and is not allowed in a 1035 exchange?

In addition to the limitations on the types of assets you’re able to exchange, the IRS has some guidelines for qualifying 1035 exchanges that you must follow. One of these guidelines is that the account owner must remain the same. You’re not able to change the owner or add an additional owner to the account when making the exchange. (You are, however, able to change the beneficiary on a life insurance account when making the exchange if you wish.)

You’re also not able to cash out a policy or annuity and use the cash to buy another. For your exchange to qualify for a 1035 exchange, the exchange must be an even transfer from one entity to another.

Exchanges can be made between institutions, meaning that you could transfer an annuity at one company to an annuity at another company. Depending on the company you’re working with, you may also be able to do a partial 1035 exchange for a portion of your life insurance or annuity, exchange multiple policies for a single one, or swap a single policy for multiple policies.

When should you do a 1035 exchange?

A 1035 exchange can be beneficial if you’re looking to make changes without incurring additional taxes. Here are some instances in which you may consider a 1035 exchange:

• You’d like to get a different type of life insurance, or you want to get more life insurance than you currently have.

• You want to take advantage of the benefits of newer annuities, like lower fees or better death and life benefits.

• You’re looking to switch to a different type of annuity (fixed vs. variable) or restructure your annuity payments.

• You’re interested in exchanging life insurance that you no longer need or want for an annuity that you can use in retirement.

How does a 1035 exchange work?

Say you purchased an annuity several years ago that is underperforming or has less favorable features than newer products, and you’d like to exchange it for a newer product with better features and fewer restrictions. After locating the like-kind annuity you’d like to swap for, you’d first reach out to the company you’d like to switch to. It will distribute paperwork to initiate the exchange (an application for the new annuity, compliance forms, and perhaps a letter to your existing annuity company). After the paperwork is completed, the two companies—both the company you’ve contracted your current annuity through and the company with the new annuity—will handle the exchange for you.

Though you likely will not be responsible for paying any additional taxes as a result of the swap, you may still need to pay a surrender charge on your existing annuity. A surrender charge is a fee you'd have to pay to end your annuity. The surrender fee may be a flat fee or a percentage of the amount you’ve paid—it will depend on the terms of your contract. Before initiating an exchange, it’s a good idea to review your existing contract and understand any potential surrender fees you may be responsible for.

Even though you won’t typically owe taxes for a 1035 exchange, you may still need to report the exchange on your tax return for that year. (This is often the case if you switch companies vs. exchanging within the same company.)

What are the advantages and disadvantages of a 1035 exchange?

There are many factors that may influence your decision whether or not to make a 1035 exchange, and there are advantages and disadvantages to making one. Here are some pros and cons you may want to consider:

Pros of a 1035 exchange

• You’re able to trade to a new (often better) product with no tax consequence.

• You can transfer funds to another annuity at your original cost basis, even if the original annuity has not performed well.

Cons of a 1035 exchange

• New contracts may have higher fees or features you may not necessarily need.

• A new contract could extend the surrender period on the asset.

• You may need to pay surrender fees on your old contract.

Is a 1035 exchange right for you?

There are several things you’ll want to think through if you’re considering a 1035 exchange. First, you’ll want to compare the features of both policies to make sure you’re not losing features you need, adding features you may not need, or incurring additional administrative charges (like surrender charges). If you’re switching companies, you’ll also want to get a feel for the new company and whether it’ll be a good fit for you. Your age and health are also factors to consider, as your health status can affect your ability to qualify for a policy, and you may be subject to premium increases, depending on your age and health.

A tax advisor can be a helpful resource when weighing this decision, providing insight on what the most tax-advantaged decision might be. If you need help understanding how this exchange might impact your overall financial plan, a Northwestern Mutual financial advisor can talk you through different options and help you make the best decision for your situation.

Northwestern Mutual also offers a range of annuities and life insurance policies that can be customized to meet your needs. If you’re interested in learning about the products and understanding which might work best for you (or qualify for a 1035 exchange for a current policy or annuity you hold elsewhere), connect with one of our financial advisors. This person will review your goals and existing assets to help you arrive at the best decision for your situation.

This publication is not intended as legal or tax advice. Consult with a tax professional for tax advice that is specific to your situation.