What is a 1035 Exchange transfer with annuities?
The Annuity Man
For people that enjoy reading the IRS tax code in their spare time, I would encourage you to flip to section 1035 and read about life insurance and annuity transfers. For those of you with an actual life, just let me explain the important details so it’s easy to understand.
Just because you can transfer your annuity via the 1035 rule doesn't mean that you should. You need to know all of the facts so you can make an informed decision before signing any paperwork.
As a short primer, life insurance companies issue annuity contracts. Under IRS Code 1035, it allows you to take your existing annuity contract (non-IRA) and transfer it to another annuity contract (non-IRA). That transfer is blessed by the IRS as a non-taxable event. The code also covers life insurance contracts as well.
But like everything in life and the financial business, it’s not that simple. So let’s take a closer look at the Internal Revenue Service 1035 exchange process, and when it does and doesn’t make sense to use this rule with your existing annuity.
The main take away from the 1035 exchange process is that it is used with non-qualified (i.e. non-IRA) annuities, and is a non-taxable event. If you remember and highlight one sentence, that is it.
The 1035 exchange process involves transferring your existing annuity (i.e. original contract) to another annuity. But not all annuities are transferable, and the receiving annuity company will approve an exchange only if it’s in the best interest of the consumer. In other words, not all transfer applications are approved. There are strict industry rules in place to make sure that it’s just not a “commission play” for the agent.
So what is not allowable in a 1035 exchange? Single Premium Immediate Annuities (SPIAs), Deferred Income Annuities (DIAs), and Qualified Longevity Annuity Contracts (QLACs) are not allowed to be transferred to another annuity because these are irrevocable (i.e. "annuitized") income contracts.
The primary product types used to transfer in 1035 exchanges are Multi-Year Guarantee Annuities (MYGAs), Fixed Index Annuities (FIAs), and Variable Annuities (VAs). All of these are classified as “deferred annuities.”
However, just to jump into the annuity acronym soup...MYGAs, FIAs, and VAs can be transferred to SPIAs, DIAs, and QLACs (in specific instances), but never in the reverse.
I know this is a little confusing...but hang in there with me.
Your Cost Basis Travels
If you decide to transfer your deferred annuity, that cost basis will transfer with it. So the gains from the original premium dollar amount put in the first policy will transfer to the new annuity. Since the transfer is a non-taxable event, the only 1035 exchange tax reporting will be from the original carrier to the new carrier.
The contract owner(s) of the original policy will be the contract owners of the new policy. In other words, the plating/ownership has to be the same with a 1035 transfer. So the way your old policy "reads" will be exactly the same on the new policy.
Big Buildings For A Reason
I always say that annuity companies have the big buildings and the large logos on their planes for a reason. They don’t give anything away and they know when we are going to die...and price things accordingly.
They also design their products so that it’s very hard to transfer to another annuity. They actually try and make their products impossible to use with a 1035 exchange. I know that sounds crazy, so let me explain.
In a 1035 exchange, only the accumulation value of the deferred annuity policy is transferable. When you add an attached benefit rider to the policy at the time of application that provides lifetime income, long term care, or an additional or enhanced death benefit….those separate policy calculations do not transfer. Not surprisingly, the attached rider amounts are typically higher than the accumulation value. That means you have to stay in the policy to access those benefits. That doesn't just happen by chance, the annuity companies design it this way in order to hold on to your money.
In addition, the surrender charges on most deferred annuities are very high and prevent you from considering a 1035 transfer because of the penalties you would incur. Initiating a 1035 transfer will trigger surrender charges if still applicable to your policy, which is another way that the carrier keeps you in their annuity.
Life Insurance vs. Annuity Exchanges
A question I receive a lot is “Can you 1035 from an annuity to life insurance?” The answer is no. The IRS Code 1035 covers both life insurance policies and annuities, but it’s a little complicated. Life insurance policy cash values can transfer to an annuity, but annuities can never be transferred to a life insurance policy. In addition, some life insurance policy types can’t be transferred at all.
Remember that life insurance is an underwritten product that involves medical testing, blood work, etc. Almost all annuities are guaranteed issue, and require no underwriting. That's the reason annuities can never be transferred to a life insurance policy.
The Math Has To Work In Your Favor
So the burning questions are, “Why would someone 1035 exchange their existing policy? or "Why would you exchange an annuity at all?” The answer is only if it’s beneficial to you, or if your financial planning goals have significantly changed.
During the application process for a 1035 annuity to annuity exchange, the receiving carrier will do a side by side benefits comparison. They want to make sure that the math is is in your favor, and that the new annuity is contractually a better deal for you.
If you can upgrade, then that's great and you need to move forward with the 1035 exchange. If not, then you will need to maximize your current policy. It's really that simple.