What Is 1035 Exchange?
A 1035 exchange is a provision in the tax code that allows a person to transfer an existing annuity to another insurer with poor ratings or other problems into a new contract issued by a financially sound carrier without paying taxes on any gains.
This can also be used to transfer an existing annuity contract into an IRA or to exchange certain types of 1035 exchange contracts.
Why Do I Need to Know About the 1035 Exchange?
If you own an existing 1035 exchange contract, this provision can save you money by avoiding taxes on gains.
For example, if you own a 1035 exchange annuity worth $100,000 and your new 1035 exchange annuity is only worth $85,000 when you cash out 10 years later, the 10% tax on the $15,000 gain does not apply.
You also avoid paying taxes on 1035 exchanges if you are transferring the 1035 exchange contract to an IRA.
For example, if you own a 1035 exchange annuity with a basis of $40,000 and the 1035 exchange contract is worth $100,000 when you roll over 10 years later, the 10% tax on the $60,000 gain does not apply because the 1035 exchange contract was transferred to an IRA.
1035 exchanges are also used for many other purposes including but not limited to gift annuities, relocating the 1035 exchange annuity to another state if you are moving or retiring, and 1035 exchanges for spouses after the death of the first spouse who had an existing 1035 exchange contract.
Who Qualifies for the 1035 Exchange?
1035 exchange is available to anyone of any income or tax bracket. They are not just for the elderly.
They are used by many different people at various stages in their lives interested in transferring an existing 1035 exchange into another contract for better terms or into a traditional IRA to take advantage of tax-deferred growth.
However, 1035 exchange provides a 10% penalty on early withdrawals, so 1035 exchange contracts are not appropriate for investors who have a requirement to pay the annuity payments before age 59 ½.
The 1035 exchange is also not usually available to retirees because they must be over 70 ½ years of age.
Who Can Help Me With My 1035 Exchange?
1035 exchange can be complicated and mistakes are costly.
The reason why this is best done by tax professionals such as accountants, financial planners, or attorneys is that 1035 exchanges require a thorough knowledge of the rules and regulations and their interpretation.
How Does 1035 Exchange Work?
You can transfer an existing 1035 exchange contract into another contract or IRA by following the rules and filling out several exchange forms.
1035 exchange rules include but are not limited to:
-The name of the transferor (the person transferring their 1035 exchange) and transferee (the person receiving the 1035 exchange);
-The date of transfer;
-The fair market value (FMV) of each 1035 exchange contract on the date of the 1035 exchange;
-Gross and net annuity payments made under each contract for each taxable year from January 1 to the date of the 1035 exchange;
After you transfer your existing 1035 exchange into another contract or an IRA, it is important to keep track of your exchange tax basis.
The 1035 exchange tax basis should be transferred to your exchange beneficiary or exchange annuity owner (the person who will receive the 1035 exchange payments) when you die.
Common Mistakes When Doing a 1035 Exchange
The following are common mistakes 1035 exchange owners makes:
-Not putting the contract into writing;
– Not transferring the 1035 exchange annuity to an IRA if it qualifies as a 1035 exchange;
– Leaving money in the original 1035 exchange contract, which means that you will not achieve tax deferral on those earnings;
– Doing the 1035 exchange contract without 10% being withheld for 1035 exchanges purposes.
How to Avoid Common Mistakes When Doing a 1035 Exchange
The following are factors to keep in mind to avoid mistakes when doing a 1035 exchange:
– Make sure your 1035 exchange with the original owner is documented in writing by the date of transfer;
-Do not sign over your 1035 exchange contract until after you have transferred it into another 1035 exchange contract or IRA;
-Do not 1035 exchange in cash or other assets 1035 exchanges in lieu of the 1035 exchange annuity.
The 1035 exchange can be a little complicated. However, this provision offers a unique way to expand your 1035 exchange options.
This allows you to move 1035 exchange contracts from one company to another or into an IRA account if the contract qualifies.
Before you do this, 1035 exchange is best done with the help of tax professionals because this requires a thorough knowledge of its rules and regulations.
About the Author
True Tamplin, BSc, CEPF®
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True contributes to his own finance dictionary, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.