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Securities Lawyer Jonathan Kurta
By: Jonathan Kurta Author

1035 Exchange Rules: What to Know Before You Make the Switch

Considering a 1035 exchange? When an investor surrenders or exchanges their annuity or life insurance policy, the IRS typically requires that the individual pay taxes on any resulting income. However, the IRS 1035 tax code provision allows investors to exchange their annuity for a new product without incurring taxes. 

Potential Benefits of a 1035 Exchange 

Brokers may tout several possible benefits of a 1035 exchange. 

  • 1035 exchanges allow investors to preserve their investments and find better annuities or other insurance products with more beneficial investments. 
  • 1035 exchanges allow investors to preserve their original investment, also known as the “cost basis.” 
  • If an insurance product’s investments do not perform well and the product loses money, an investor can exchange one for another without realizing any losses. 

What Qualifies as a 1035 Exchange? 

1035 exchanges involve non-qualified annuities and insurance products paid for by already taxed money. Qualified annuities are not part of 1035 exchanges because the investor has already paid taxes. 

The IRS allows the following 1035 exchanges. 

A life insurance policy in exchange for:

  1. Another life insurance policy, 
  2. An endowment, or 
  3. An annuity contract 

An endowment in exchange for:

  1. Another endowment contract 
  2. An annuity contract

An annuity contract in exchange for:

  1. Another annuity (Investors should note: 1035 exchanges only apply if the annuity is for the same insured person. You cannot switch an annuity for one person in exchange for an annuity for another person.) 

What Does Not Qualify as a 1035 Exchange?

The IRS stipulates that Section 1035 exchange rules do not apply to the following: 

  • Exchanges of an endowment for a life insurance contract 
  • Exchanges of an annuity for a life insurance contract
  • Exchanges of an annuity for an endowment 

Red Flags: Questions to Ask Before a 1035 Exchange 

Many 1035 exchanges do not work to the investor’s advantage but serve only to line their broker’s pockets. Brokers may have a significant financial incentive to recommend a 1035 exchange. Their commission can be as much as 7% of the annuity contract’s first deposit. Compare that with the commission for buying and selling stocks, which is typically only around 1%. Kathleen Hunter, assistant vice president of marketing at Pacific Life Insurance Co., addressed large commissions for 1035 exchanges in an article for The Wall Street Journal: “We looked at this whole phenomenon and said ‘This has got to stop.’” She suggests brokers should instead be paid a small commission for every year of the annuity. 

Variable Annuities and 1035 Exchanges 

Investors should be especially wary of brokers who recommend switching from a fixed-rate annuity to a variable annuity. Variable annuities are some of the most poorly written contracts in the financial sector. They may come with exciting features, like a death benefit that pays a lump sum to beneficiaries, with no income tax burden. But those death benefits can come with steep fees, called the mortality and expense charges (M&E). These fees typically cost 1% to 2% of the total amount of the variable annuity contract. The M&E grows as the balance of the account grows. 

Surrender Periods 

Investors may lose money if they try to perform a 1035 exchange before the surrender period has arrived — the average surrender period for an annuity is six years. Investors who surrender before the six years are up must usually pay a surrender fee, which may nullify any benefit to the proposed switch.  Surrender fees on top of a broker commission might make the new contract too expensive for the exchange to be profitable. 

Insurability of the Investor

The new annuity may have higher costs, given the insurability of the investor. For example, health problems can increase the cost of the policy. 

Boot: Taxable Gains Under the Original Contract 

Annuities may come with a boot that investors need to take into account before a 1035 exchange. Boot is any value gained under the old contract that does not transfer to the new contract. This could be a loan taken out under the old annuity or any cash withdrawals made shortly before the exchange that do not transfer to the new contract. Investors should make sure they understand the implications of any boot before they go through with the 1035 exchange.  If an investor has a loan against their original annuity not mirrored in their new insurance product, taxes could result from the release of the loan. 

Partial 1035 Exchange Rules 

Annuitants may also exchange a portion of their annuity for a different annuity without incurring any taxes. Different companies have different rules regarding a partial 1035 exchange for an annuity—for instance, some companies will not allow annuitants to partially exchange an annuity for a life insurance policy. 

To qualify as a partial 1035 exchange, the IRS requires that annuitants not take any distributions for 180 days following the exchange. 

Partial 1035 Exchange: Long-Term Care Insurance 

Partial 1035 exchanges can pay for a long-term care insurance policy. Instead of giving up the annuity entirely, the annuitant can pay for their long-term care insurance with part of their annuity. This results in favorable tax treatment. 

The IRS and Partial 1035 Exchange Abuse 

The IRS has rules in place to prevent partial 1035 exchange abuse. For instance, annuitants must withdraw income generated by the annuity’s returns before receiving a tax-free return of principal. Certain investors might use a partial exchange to divide the income to reduce the taxable return they must withdraw to preserve the tax-free return on principle. If the IRS catches an annuitant attempting to reduce their taxable income with a partial 1035 exchange, there could be severe tax consequences. 

Questions to Ask Your Broker Before a 1035 Exchange 

It is the broker’s responsibility to communicate the benefits and possible downsides of a 1035 exchange. Before the switch, investors should ask the following questions: 

  • How has the new annuity performed historically? 
  • How is the broker being paid? How much is their commission? 
  • Will my health affect the premium for the new annuity? If an annuitant’s health status has changed, that could affect the cost of the exchange. 
  • Could I get the same benefit without a 1035 exchange? It might be just as beneficial to purchase additional coverage from the original insurer in some cases. 

Unsuitable Recommendations

Brokers have an obligation to only recommend suitable investment products under FINRA Rule 2111. For instance, if a broker recommends that an investor switch from a fixed-rate annuity to a variable annuity, they may not have their customer’s best interests in mind. Investors should always approach variable annuities with caution, as they are complex contracts that come with high fees. 

Investors typically sign a contract that contains an arbitration agreement, which prevents investors from suing. Instead, investors must go through FINRA arbitration to recover their investment — at which point a securities attorney could prove an invaluable resource. Contact Kurta Law today if you believe your broker may have recommended an unsuitable 1035 exchange.



Securities Lawyer Jonathan Kurta
Written by: Jonathan Kurta

Jonathan Kurta is an accomplished securities attorney and a founding partner at Kurta Law.