1035 Exchange

A Section 1035 exchange allows a policyowner to:

1. A.Exchange one life or annuity contract for another tax-freeCorrect - 1035 exchanges defer tax.
2. B.Take a policy loanA policy loan is available under the contract's own loan provision and needs no special tax rule. Section 1035 exists for a different problem: swapping one contract for another without recognizing gain in the process.
3. C.Change the beneficiaryA contractual right the owner exercises by filing a change form. It carries no tax consequence, so there is nothing for a nonrecognition provision to do.
4. D.Withdraw cash value tax-freeConflates a nontaxable exchange with a tax-free distribution. Section 1035 defers gain precisely because the value never leaves the insurance wrapper; it says nothing about pulling cash out, which is governed by separate distribution rules.

Why: A 1035 exchange permits a tax-free exchange of one life insurance or annuity contract for another qualifying contract.

A Section 1035 exchange allows an investor to...

1. A.Turn a variable annuity into a Roth IRAThat is a different transaction; 1035 covers exchanges between annuity or life policies.
2. B.Withdraw funds early and avoid any surrender chargeA 1035 exchange addresses taxes, not surrender charges, which may still apply.
3. C.Convert an annuity into a bank CD tax-freeA CD is not an eligible insurance product for a 1035 exchange.
4. D.Exchange one annuity for another without triggering current taxCorrect — that is the purpose of a 1035 exchange.

Why: A 1035 exchange permits a tax-free exchange of one annuity or life insurance policy for another, deferring tax on any gains.

Solveig owns a nonqualified deferred annuity worth 400,000 dollars with an investment in the contract of 250,000 dollars. She wants to move only HALF of the value into a different annuity contract with another carrier while leaving the other half where it is, and she wants the move to be tax free. Which statement is correct?

1. A.Section 1035 requires a complete exchange, so she must move the entire 400,000 dollars or recognize gainPartial annuity to annuity exchanges are permitted. There is no all or nothing requirement.
2. B.The exchange is permitted but the 150,000 dollars of gain in the contract must be recognized on the half that is movedA qualifying 1035 exchange defers gain entirely. No gain is recognized on the transferred portion.
3. C.A partial 1035 exchange is permitted, and the 250,000 dollars of basis is allocated pro rata, so 125,000 dollars of basis follows the transferred halfCorrect. Partial annuity-to-annuity exchanges qualify under Section 1035 with proportional basis allocation.
4. D.The exchange is permitted, and she may elect to carry ALL 250,000 dollars of basis to the new contractBasis allocation is proportional to the value moved. The owner cannot choose which contract keeps the basis.

Why: A partial exchange of one nonqualified annuity for another is permitted under Section 1035 and is tax free if properly executed as a direct carrier to carrier exchange. The key mechanical point is that the investment in the contract is allocated PRO RATA between the surviving old contract and the new one, in the same proportion as the value transferred. Moving half the value carries over half the basis: 125,000 dollars of basis follows the 200,000 dollars to the new contract, and 125,000 dollars stays with the retained contract. Basis cannot be steered preferentially to one side.

Ignacio, 61, owns a nonqualified deferred variable annuity with a 90,000 dollar value and a 55,000 dollar cost basis. He asks his representative whether he can move it, without current tax, into (i) a long-term care insurance contract, or (ii) a variable life insurance policy on his own life. What is the correct answer?

1. A.The long-term care exchange qualifies under Section 1035, but the exchange into life insurance does not and would trigger tax on the 35,000 dollars of gainCorrect. Annuity to annuity and annuity to qualified long-term care are permitted directions; annuity to life insurance is not.
2. B.Both qualify, but only if the same insurance company issues the replacement contractA 1035 exchange may be made between different carriers. Same-carrier status is not a condition of tax-free treatment.
3. C.Neither qualifies, because Section 1035 applies only to exchanges between two annuity contractsThis is too narrow. Qualified long-term care contracts were added as permitted recipients of annuity value.
4. D.Both qualify, because Section 1035 covers all exchanges among life insurance, endowment, annuity and long-term care contractsSection 1035 lists permitted directions, not a free-for-all. The statute deliberately blocks annuity-to-life exchanges.

Why: Section 1035 permits tax-free exchanges only in permitted directions. An annuity may be exchanged for another annuity or for a qualified long-term care contract, but an annuity may not be exchanged tax-free for a life insurance policy. Life insurance may move down the ladder into an annuity, never the reverse. The rule reflects the fact that life insurance receives a more favorable tax treatment at death, so the tax code will not let untaxed annuity gain migrate into it. The clue is the direction of each proposed exchange. Review: Section 1035 exchanges. Trap: assuming 1035 works both ways between life and annuity.