1035 Exchanges For Annuities

Annuity ExchangesBy Toma Franklin, Staff Writer

The replacement of an existing annuity with a new one, purchased from a different company, without any tax consequences, is known as a 1035 exchange. Taking it's name from Internal Revenue Code 1035, a 1035 exchange stipulates that certain requirements be met before funds can be transferred from one annuity to another. Thus a 1035 exchange allows the annuity owner to exchange outdated or under-performing contracts and replace them with a more efficient annuity product, while the IRS helps out by not recognizing any gains when the old contract is voided, and allows the entire sum to be transferred to the new contract, thus preserving and continuing the tax benefits provided by the old contract.

One of the main reasons for using a 1035 exchange is to avoid current income taxation on gain. While the IRS allows a nontaxable exchange, the interpretation of an exchange is severely implemented. It is not permissible to surrender the old contract, receive a check and then invest into a new contract. For a valid 1035 exchange, the transfer must take place directly between the two insurance companies. Another valid reason for using a 1035 exchange is to preserve the adjusted basis of an old annuity.

Rules Governing a 1035 Exchange

The basic rules governing a 1035 exchange of annuities are clear and simple. The owner of the new annuity must be the same as the old one. A life insurance policy, endowment or annuity can be exchanged for a new annuity. Please note that the word exchange here does not mean a two way process. An annuity cannot be exchanged into a life insurance contract under 1035 rules.

Any number of old contracts can be combined into one new annuity, so long as all the contracts, old and new, are under the same name. The adjusted basis of the new contract is the sum of the adjusted basis of all the old contracts. Changing from an immediate annuity to a deferred annuity can qualify as a valid 1035 exchange. However, non-applicability of the 10% early surrender penalty will depend upon which of the exceptions of IRC 72 the annuity buyer qualifies for.

You are also allowed to make partial 1035 exchanges, where you transfer a portion of the cash value of an annuity to another annuity contract without any taxes kicking in. Please note that the IRS and issuing insurance companies have rigorous checks in place to make sure that this facility is not abused for tax avoidance purposes. Any further transfer or distribution within 24 months from a new annuity which has been previously funded from partial portions of an old annuity automatically trigger transaction inspections and can result in reduction of certain benefits. If you are planning a partial 1035 exchange, you are advised to consult with your financial advisor.

How 1035 Exchanges can be critical to Investors

1035 exchanges are a valuable and valid tool for investors to move out of outdated or inefficient annuity contracts without losing cash value in taxes. Due to fierce competition in the insurance industry, most often an insurance company will offer special benefits to an annuity holder as an additional incentive to switch over. In case the transaction does not fall under a 1035 exchange, insurance companies are even offering to make up for the loss with increased return rates.

With so many positives, it is hard to understate the benefits of a 1035 exchange. You are, however, advised to consult a financial planner, research the new annuity issuing company and calculate the exact long term benefits from the exchange.

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