1035 Exchange (Taxation) - Explained
What is a 1035 Exchange?
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Table of ContentsWhat is a Section 1035 Exchange?How Is a 1035 Exchange Used?How Does A 1035 Exchange Work?Academic Research on Section 1035 Exchange
What is a Section 1035 Exchange?
Replacing a life insurance policy or an annuity with a new one without paying any additional taxes as a consequence of this exchange is referred to as Section 1035 Exchange as per the Internal Revenue Code (IRS) of the United States.
How Is a 1035 Exchange Used?
A 1035 Exchange provides the benefit of changing annuity schemes without inviting extra taxes. Owners can swap in better performing bonds and shares while discarding outdated and lossy portfolio items without restrictive tax measures limiting their investment options. It also facilitates policy holders in preserving their basis in the absence of deferred gains. For e.g., X invests $10,000 in a non-qualified annuity. No withdrawals or loans are recorded on this investment. Due to poor performance of the underlying assets, the value of this annuity drops to $8000. X decides to choose better performing options with a different firm in lieu of the poor policy currently in his portfolio. A Section 1035 Exchange facilitates the transfer of this policy at the cost of the original investment of $10,000 as the basis of the new contract, even as the actual value of money transferred is $8000.
How Does A 1035 Exchange Work?
Although a 1035 Exchange facilitates easy swapping in and out of different policies, it doesn't absolve the owner of any payments due or transaction and operational fee incurred on such exchanges. Transfers within the same firm might have the provision of a transaction fee waiver, but not always. It only allows exchange between similar contracts, for e.g., a Modified Endowment Contract (MEC), can only be traded in for another MEC. Theres no change in the status or nature of the contract. Similarly, a life insurance policy can only be exchanged with another life insurance policy. Money transfers from one policy account to another are direct and the owners cannot act as intermediaries. Also, owners of old and new policies should also remain the same. 1035 Exchanges do not allow transfer of policies from one owner to another, nor does it allow exchanges between joint account holders. X cant exchange his policy in for another one where his account also has another owner Y. Section 1035 Exchanges are very popular as they ease portfolio diversification, even when only a partial policy exchange occurs. In such exchanges, a percentage of the cost basis is diverted towards the new products.