What it means
Normally, surrendering an annuity or a cash value life insurance policy triggers tax on any gain, which is the difference between what it is worth and what was paid in. A 1035 exchange avoids that tax bill for as long as the money moves directly from one qualifying contract to another.
The tax is not cancelled, only pushed back to the day money is eventually taken out. The rules allow certain like-for-like swaps, such as life insurance to life insurance, life insurance to an annuity, and annuity to annuity.
Long-term care contracts can also be involved. A swap from an annuity into a life insurance policy is not permitted.
People use the exchange to move to lower fees, better investment choices, a stronger insurer or different features. The new contract keeps the original cost basis (the amount paid in), so the deferred gain is still there and will be taxed later when money is taken out.
For that reason, the exchange is a way of changing product, not of escaping tax. Mechanics matter.
The money must go straight from one insurer to the other rather than through the owner's hands, and the owner generally needs to be the same on both contracts. Receiving the cheque personally can turn the transaction into a taxable surrender.
The exchange is not free of cost. The old contract may charge surrender fees (penalties for leaving early), the new one may begin a fresh charge period, and the owner may lose valuable guarantees attached to an older policy.
Because the tax treatment and the contract terms are complex, owners should ask both the old and new insurers for a written comparison. A tax adviser can confirm whether the specific swap qualifies and how the cost basis will carry across.
It is also wise to ask whether any death benefit or income guarantee on the old contract would be lost.
In practice
Real-world examples.
Example
A retired teacher holds an older annuity that charges annual fees of 2.5%. She exchanges it for a low-cost annuity from another insurer, moving $90,000 directly between the companies. She avoids an immediate tax bill and reduces her yearly charges.
Example
A business owner has a whole life policy that he no longer needs to protect the company. He exchanges it for an annuity to provide retirement income without a tax charge on the policy's accumulated gain. His adviser checks that the old policy has no outstanding loan that could cause a taxable amount.
Example
A widow inherits a life insurance policy with a cash value of $70,000 and wants a guaranteed income. She uses an exchange to move into an annuity within the permitted rules. A tax adviser confirms the paperwork before the transfer is made. The insurer then sends the cash value directly to the new company, so she never handles the money.
Formula
Calculation
Gain deferred = Contract value - Cost basis
Tax avoided now = Gain deferred x Tax rate
Suppose an annuity is now worth $150,000 and the owner has paid in $100,000. The gain is 150,000 - 100,000 = $50,000. If the owner simply surrendered the contract and was taxed at an assumed rate of 24% on the gain, the bill would be 50,000 x 0.24 = $12,000. With a 1035 exchange, that $12,000 is deferred, and the whole $150,000 continues to grow inside the new contract.Case study
Seen in the real world.
Fernhill Advisory is an illustrative, fictional financial planning firm helping a client, Mr Okafor, who owns a variable annuity worth $240,000 with a cost basis of $160,000. The annuity charges 2.2% a year, and a competing contract offers similar features at 1.1%.
The adviser calculates the annual saving as 240,000 x 1.1% = $2,640, and the deferred gain as 240,000 - 160,000 = $80,000. She also checks that the existing contract has no surrender charge left, since an early exit penalty would erode the benefit.
Mr Okafor completes a direct insurer-to-insurer transfer. The illustrative lesson is that the saving was real, but only because the paperwork was done correctly and the old contract's charge period had already ended.
Watch out
Common mistakes.
- Taking a cheque personally and then paying it into the new contract, which can turn a tax-free exchange into a taxable surrender.
- Assuming the exchange removes the tax, when it only postpones it until money is withdrawn.
- Ignoring surrender charges and lost guarantees on the old contract, which can outweigh the savings from lower fees.
Questions
People also ask.
Can an annuity be exchanged for a life insurance policy?
No, the rules do not permit that direction, although a life insurance policy can be exchanged for an annuity.
Does a 1035 exchange reset the cost basis?
No, the basis carries across from the old contract, so the deferred gain is taxed when the new contract is paid out.
Is a 1035 exchange available outside the United States?
It is a feature of United States tax law, so owners elsewhere should look to their own country's rules for similar relief.
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