Section 1035 of the Internal Revenue Code provides a powerful tool for policyholders and annuity owners to exchange certain insurance and annuity contracts without triggering immediate tax consequences. While Section 1035 is most commonly associated with non-qualified (after-tax) annuities and life insurance, it also has important implications for qualified retirement assets — those held within tax-advantaged retirement plans such as IRAs, 401(a), 403(a), and 403(b) annuities.

What Is a Section 1035 Exchange?

Section 1035(a) provides that “no gain or loss shall be recognized on the exchange of:

  • A contract of life insurance for another contract of life insurance or for an endowment or annuity contract or for a qualified long-term care insurance contract or
  • An annuity contract for an annuity contract or for a qualified long-term care insurance contract.”

The intent is to allow taxpayers to replace an existing contract with another better suited to their needs, without being forced to recognize gains simply because of the exchange.

Qualified vs. Nonqualified Assets

The classic Section 1035 exchange involves non-qualified contracts purchased with after-tax dollars. However, many retirement savers hold annuity contracts within qualified plans, such as IRAs, 401(a), 403(a), and 403(b) arrangements. The tax treatment of exchanges within these plans is governed by both Section 1035 and the specific rules applicable to the qualified plan.

Direct Transfers: The Key to Tax Deferral

For a Section 1035 exchange to be tax-free, the transaction must be a direct exchange between insurance companies, with no constructive or actual receipt of funds by the policyholder. This is especially critical for qualified assets. The IRS has consistently ruled that a direct transfer of a policyholder’s interest in an annuity contract from one insurance company to another — whether due to insolvency, plan changes, or other reasons — does not result in a taxable distribution, provided the transfer is direct and the new contract is held within the same qualified plan.

Pitfalls: Indirect Transfers and Distributions

If the policyholder receives the proceeds of the old contract — even momentarily — before funding the new contract, the transaction is treated as a taxable distribution, not a tax-free exchange. This is true even if the funds are immediately used to purchase a new annuity. The IRS has made clear that if a check is issued to the policyholder (or deposited in their account), and then used to fund a new contract, the transaction is taxable to the extent of the gain in the original contract.

Qualified plans may allow for rollovers of distributions, but Section 1035 does not provide a rollover window for non-qualified annuities, and the rules for qualified plan rollovers (such as the 60-day rule) are separate and distinct from Section 1035. For qualified annuities, a direct trustee-to-trustee transfer is required to avoid current taxation.

Special Considerations for Qualified Plans

  • Plan Requirements: The new contract must be subject to the same plan requirements (e.g., distribution restrictions, no transferability) as the old contract.
  • Reporting: Direct transfers within qualified plans are generally not reportable as distributions on Form 1099-R, but exchanges between insurance companies may be reportable events for non-qualified contracts.
  • Loans: If the old contract has an outstanding loan, the discharge of the loan as part of the exchange may trigger taxable income to the extent of the gain in the contract.

How It Looks Practically

John and Jane Smith are a married couple in their eighties. John owns an annuity, and Jane is named as the beneficiary. When John passes away, Jane, as the beneficiary, will receive the death benefit from John’s annuity. Instead of taking the entire death benefit as a lump-sum distribution — which would trigger immediate taxation — Jane can elect to complete a Section 1035 exchange. This means she can transfer the death benefit value from John’s annuity directly into an annuity contract in her own name, allowing her to defer the income taxes on the gain. By doing so, Jane can withdraw the funds gradually over time, spreading out the tax liability rather than recognizing it all at once. For tax reporting purposes, Jane will receive a Form 1099-R from John’s annuity, with a distribution code of 6, indicating that the funds were transferred via a tax-free Section 1035 exchange.

Conclusion

A Section 1035 exchange can be a valuable tool for updating or consolidating annuity contracts within qualified retirement plans, but strict adherence to the direct transfer requirement is essential. Any deviation — such as receiving a check — can result in immediate taxation.

Please reach out to your KT Tax Advisor for advice related to your specific tax situation.