7.5 Section 1035 Exchanges
Section 1035 of the Internal Revenue Code allows policyowners to exchange an existing insurance policy or annuity contract for another policy without triggering current taxation on any accumulated interest or investment gains. These transactions are known as 1035 exchanges and are often used when a new policy offers improved features, benefits, or more suitable coverage than the existing contract.
Even though the exchange itself may be tax free, policyowners should be aware that surrender charges may apply to the existing policy, and the new contract may begin a new surrender charge period. Additionally, the new policy may include different fees, expenses, or loan costs, which could affect the overall value of the contract.
The IRS permits the following tax-free exchanges under Section 1035:
- Life insurance to life insurance
- Life insurance to an annuity
- Annuity to an annuity
- Life insurance or annuity to long-term care insurance
However, an annuity cannot be exchanged for life insurance under Section 1035.
When exchanging one life insurance policy for another through a 1035 exchange, the new policy will only be issued after the policyowner completes a new application and the insurer approves and issues the coverage.
Quiz
1. What is the primary purpose of a Section 1035 exchange?
A. To eliminate surrender charges on existing policies
B. To allow the exchange of insurance contracts without current taxation on gains
C. To convert life insurance policies into retirement plans
D. To reduce the death benefit of an existing policy
Correct Answer: B
Rationale: Section 1035 of the Internal Revenue Code allows policyowners to exchange one insurance or annuity contract for another without triggering immediate taxation on accumulated interest or investment gains. This provision helps maintain tax-deferred status when replacing policies.
2. Which of the following exchanges is permitted under Section 1035?
A. Annuity to life insurance
B. Life insurance to life insurance
C. Long-term care to life insurance
D. Annuity to disability insurance
Correct Answer: B
Rationale: The IRS allows several tax-free exchanges, including life insurance to life insurance, life insurance to annuity, annuity to annuity, and life insurance or annuity to long-term care insurance. However, annuities cannot be exchanged for life insurance.
3. Which of the following exchanges is not allowed under Section 1035?
A. Life insurance to annuity
B. Annuity to annuity
C. Annuity to life insurance
D. Life insurance to long-term care insurance
Correct Answer: C
Rationale: Section 1035 does not permit exchanging an annuity for a life insurance policy. This restriction prevents the conversion of retirement-type investments into life insurance while maintaining tax deferral.
4. What potential cost should policyowners consider when performing a 1035 exchange?
A. Immediate income tax on gains
B. Required capital gains tax
C. Possible surrender charges on the existing policy
D. Mandatory penalty taxes
Correct Answer: C
Rationale: Although the exchange itself may be tax free, policyowners may still face surrender charges on the old policy, and the new contract may begin a new surrender charge period with different fees or expenses.
5. What must occur before a new life insurance policy can be issued in a 1035 exchange?
A. The insured must pay a tax penalty
B. The policyowner must complete a new application and the insurer must approve the policy
C. The existing policy must mature
D. The insured must reach age 59½
Correct Answer: B
Rationale: When replacing one life insurance policy with another through a 1035 exchange, the new policy is issued only after a new application is submitted and approved by the insurer, ensuring proper underwriting and contract acceptance.