1035 exchange: What it is & how it works

Life insurance and annuities can help you stretch your income—allowing your money to grow and care for your loved ones even after you're gone. But sometimes, despite taking these critical steps toward financial wellness, things change—families expand, and so do your needs. Your previous insurance-contract investments may no longer be as ideal for you as they once were.

Instead of surrendering an old contract and starting again with a new one, you may want to consider a transfer called a 1035 exchange—a contract-to-contract transaction that comes with tax advantages.

When you do a 1035 exchange, you're trading in an annuity, endowment, life insurance or long-term care insurance contract for a new, similar contract of qualified eligibility. And deferring taxes on any gains.

For example: Say your family has grown over the years, and you realize you want more life insurance than your current policy provides. After shopping for a product that better fits your needs, you let your current and new insurance providers know you'd like to do a 1035 exchange. The two companies then work together to handle the transfer details.

While you may incur some transactional fees, this method lets you avoid paying the income taxes you would have to pay if you were to terminate the old contract and withdraw all your money to put into a new contract. That's because with a 1035 exchange, you aren't taking out any of your money; you're just moving it to another eligible investment.

1035 exchanges can be thought of simply as "swapping contracts," but there are a few IRS rules to know and follow so you can take advantage of tax efficiency and preserve more of your money. If you have questions about qualifications or what is not allowable in a 1035 exchange, connect with your financial advisor and tax professional.

The assets you're trading must be the same kind of product or be one of the allowable exceptions. For example, you can exchange a life insurance contract for a nonqualified annuity, endowment or for long-term care life insurance. But an endowment only can be swapped for another endowment, a nonqualified annuity or long-term care insurance.

Transferring ownership during the transaction would nullify eligibility for the 1035 tax benefits.

You can't cash out the contract or take money from it. The exchange must go straight from one institution to another to avoid incurring income taxes.

First, understand how your lifestyle, means, goals and needs have changed and where your current contract falls short. Then you can know what to look for in a new contract.

Once you find a more preferable contract, tell your current provider you'd like a 1035 exchange on your current contract for the new one. You'll then complete and submit paperwork for the company to finish the transaction. If you're transferring funds to a new provider, there may be additional paperwork to ensure both companies have the information they need to facilitate the exchange.

After all paperwork is completed and accepted, the funds should be transferred directly from one account to the other.

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This financial strategy can offer major tax benefits if you need to swap your life insurance or annuity for products that better meet your needs. Still, it may not be suitable for everyone. Consider these benefits and drawbacks of a 1035 exchange:

• Tax-deferral continuity. You can transfer funds from one contract to another without paying taxes on any gains throughout the process.
• Preserving cost basis. If the contract has underperformed and dropped in value, you may be able to initiate a 1035 exchange for the product at its original value.
• Better benefits and terms. It's possible to find a more desirable life insurance or annuity contract, such as one with more insurance coverage or a better-performing annuity with lower fees.

• Potential exchange fees. There may be expenses associated with your new contract, including a broker commission, that can eat into its value. You also may have to pay a surrender charge on your old contract.
• Higher costs. If you're exchanging for a new life insurance contract, it can come with a higher cost based on your age and your health, or you may not be eligible at all. If you're exchanging for an annuity, be aware that some may have new features that result in higher fees.
• Tax noncompliance. Failing to comply with IRS rules—such as taking out any cash or exchanging a contract with outstanding loans—could leave you with a tax bill.

Before you initiate an exchange, ask yourself:

• What is the total cost, including surrender charges, broker commission and payments for any outstanding loans?
• Does the new contract have the benefits I need, and am I paying extra for features I don't need?
• Does the timing work for my family? For example, will resetting my life insurance contestability period put my family at risk? Will my age and health disqualify me from insurance altogether?

Even though you don't pay an income tax on any gains, you typically still need to report a 1035 exchange when filing your taxes, using form 1099-R.

You do not have to report an exchange on your taxes if the transfer fits all three of these situations:

• The company that issued your current policy will be the same one that will handle your new policy.
• Your exchange qualifies as an eligible, in-kind exchange with no money cashed out.
• The company maintains an adequate record of your account.

If you need to trade an insurance or annuity product for one that better suits you, your family and your finances, a 1035 exchange may be a wise choice. But the rules and implications can be complicated. A financial advisor can help you understand the ins and outs so you can decide if it's right for you.