Is a Section 1035 Exchange Right for You?
Why did you buy the annuity or life insurance policy in the first place? Was it for guaranteed growth? Or were you looking to use it for tax deferral? Or to provide a benefit to your family at death? Does your reason for buying the annuity policy still apply?
What if you purchase an annuity and later find that a different type of annuity is better for you? Surrendering your annuity early can be costly. On top of a potential surrender charge of as much as 15 percent, you could also be hit with a 10 percent tax penalty if you’re not 59 ½ years old yet. Plus, you will owe income tax on any profit — or annual return — you’ve made on the annuity.
But you can avoid at least the tax consequences with a 1035 exchange. If you purchase an annuity and later find an annuity with better terms, there is a provision in the law that permits exchanging one annuity for another, as long as the person who holds the contract doesn’t change.
Section 1035 of the Internal Revenue Code, which also applies to life insurance policy exchanges, governs annuity exchanges. Named for the section that regulates them, Section 1035 exchanges also allow the exchange of a life insurance policy for an annuity — but not the exchange of an annuity for a life insurance policy.
There are important restrictions on 1035 exchanges. You may use it only to roll one annuity over into another annuity. If you try to cash out your annuity and use the money to purchase another annuity, the law won’t cover that exchange, and you will not be spared the tax consequences.
In 2013, the IRS ruled that people who inherit annuities may also qualify for a 1035 exchange, as long as they follow all the other rules for inherited annuities. For example, nonqualified annuities can’t be exchanged for qualified annuities.
The IRS allows the exchange of multiple annuity contracts for a single contract, one contract for multiple contracts, and a portion of an annuity for an alternate annuity.
So the burning questions are....
“Why would someone 1035 exchange their existing policy? or "Why would you exchange an annuity at all?” The answer is only if it’s beneficial to you, or if your financial planning goals have significantly changed
During the application process for a 1035 annuity to annuity exchange, the receiving carrier will do a side by side benefits comparison. They want to make sure that the math is is in your favor, and that the new annuity is contractually a better deal for you.
If you can upgrade, then that's great and you need to move forward with the 1035 exchange. If not, then you will need to maximize your current policy. It's really that simple.
Financial 411 offers a free 1035 exchange-evaluation service that compares an existing annuity to newer products on the market.
All 1035 exchanges, whether full or partial, require serious thought. Only after careful examination of available alternatives can you decide if a 1035 exchange makes sense for your individual situation.