'1035 Exchange' is explained in detail and with examples in the Retirement edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.
A 1035 Exchange is an exchange process that permits individuals to replace their existing life insurance policy or annuity contract with a similar new contract or policy. Thanks to a provision in the tax code, this can be affected without suffering any negative tax repercussions as part of the trade off exchange. The Internal Revenue Service permits those who hold these kinds of contracts to update their old policies and annuities with those more modern ones that include better benefits, superior investment choices, and lower fees.
The 1035 Exchange is also called a Section 1035 Exchange after the tax code section for which it is named. It literally permits policyholders to transfer their funds out of an endowment, life insurance policy, or annuity into a newer similar vehicle. The way it works is to allow holders to defer their gains. When all of the received proceeds of the original contract become transferred to the newer contract (as there are simultaneously not any loans outstanding on the prior policy), no tax becomes due at point of exchange. Should these proceeds be received and not exchanged according to the 1035 Exchange rules, then all gains obtained out of the first contract become taxable like ordinary income, and not as capital gains.
Gains do not refer to all money received. Instead they are the result of subtracting the gross cash value from the premium tax basis. This basis refers to the original dollar amount put into the contract itself minus the premiums paid for extra benefits or any distributions which qualify as tax free.
In order for this 1035 Exchange to make sense, it has to benefit the policy holder either economically or personally. It is also important for holders to never terminate their in place insurance policies until the newer policy has been fully issued and becomes effective. The holders need to contemplate any health changes since the original policy started. It might cost extra premiums in order for the newer policy to cover them. They might even receive a denial of coverage if the changes in health are too drastic. Similarly, if the holder is well advanced in age, the premium rate may increase.
Some policies also have surrender charges that must be considered. There may be different guarantees, provisions, and interest crediting in the newer policy as well. Most importantly, benefits of the newer policy have to be carefully reviewed. These may change negatively in some cases.
There are rare cases where simply surrendering an existing insurance policy or annuity is more advantageous than engaging in a 1035 Exchange. These primarily occur when the existing contract offers no gain. Sometimes outstanding loans on the initial policy also decrease the benefits of an exchange. In other cases, the original policy may have a “market rate adjustment” type of provision. This would cause the exchange proceeds to be less than those offered in a surrender.
It is usually the case that such a 1035 Exchange will be slower and more involved than simply surrendering the holder’s original policy. It can even require a few months much of the time. This is why the conditions that affect the practicality of the exchange include financial conditions of the initial policy carrier, the country’s economic climate at the time, and the intentions of the policy holder.
The IRS only deems certain exchanges to be considered “like kind” and allowable. These include life insurance for life insurance, life insurance for non-qualified annuity, life insurance for endowment, endowment for non-qualified annuity, endowment for endowment, and non-qualified annuity for non-qualified annuity. They also will allow multiple numbers of existing contracts to be changed into a single newer contract. It does not work in reverse. A single existing contract can not be exchanged in for multiple newer contracts, per the IRS rules and regulations.