zaro

What Does a 1035 Mean?

Published in Tax-Deferred Exchange 3 mins read

A "1035" primarily refers to a 1035 exchange, a specific provision in the U.S. tax code that allows for the tax-free transfer of funds from one insurance or annuity product to another of a similar type. This financial maneuver, permitted under Section 1035 of the Internal Revenue Code, enables individuals to swap policies without triggering immediate taxes on any accumulated investment gains.

Understanding the 1035 Exchange

The core purpose of a 1035 exchange is to provide flexibility for policyholders who wish to update or change their insurance or annuity contracts without incurring an immediate tax liability on their policy's growth. Without this provision, liquidating an old policy to purchase a new one would typically result in taxable income on any gains.

Key aspects of a 1035 exchange include:

  • Tax Deferral: It allows for the deferral of taxes on investment gains until funds are ultimately withdrawn from the new policy.
  • "Like-Kind" Requirement: The exchange must involve products considered "like-kind" by the IRS to qualify. This ensures the spirit of the rule, which is to continue the deferral for similar financial vehicles.
  • Direct Transfer: The exchange generally requires a direct transfer of funds from the old policy provider to the new one, rather than the money passing through the policyholder's hands.

Eligible Products for a 1035 Exchange

The "like-kind" requirement means that certain types of insurance and annuity products can be exchanged for others without triggering a taxable event. The following table illustrates common eligible exchanges:

From (Original Policy) To (New Policy)
Life Insurance Policy Another Life Insurance Policy
Life Insurance Policy Annuity Contract
Life Insurance Policy Long-Term Care Insurance Policy
Annuity Contract Another Annuity Contract
Annuity Contract Long-Term Care Insurance Policy
Endowment Contract Another Endowment Contract
Endowment Contract Annuity Contract
Endowment Contract Long-Term Care Insurance Policy
Long-Term Care Policy Another Long-Term Care Policy

It is important to note that, while the above exchanges are generally permitted, an annuity cannot be exchanged for a life insurance policy, nor can a long-term care policy be exchanged for an annuity, as these would not be considered "like-kind" under the current rules.

Why Utilize a 1035 Exchange?

Policyholders often consider a 1035 exchange for various reasons, including:

  • Better Policy Features: Gaining access to new policy features, lower fees, or improved investment options offered by a different provider or a newer product.
  • Changing Needs: Adapting to evolving financial goals, family situations, or estate planning strategies. For example, converting a life insurance policy to an annuity for retirement income.
  • Improved Financial Strength: Moving to a company with a stronger financial rating.
  • Consolidation: Combining multiple smaller policies into one larger, more manageable contract.

While a 1035 exchange offers significant tax advantages, it's crucial to evaluate the new policy's terms, fees, and suitability for individual financial goals before proceeding. For more detailed information, consider visiting the official IRS website or consulting reputable financial planning resources.