Section 1035 Exchange

A 1035 exchange refers to the US Internal Revenue Service Section 1035, which addresses the specific transfer of funds between a life insurance policy, endowment policy or annuity policy.

Under 1035 exchange rules, tax-free exchange treatment is appropriate for individuals who have merely exchanged one insurance policy for another that is better suited to their needs and who have not actually realized any gain. 

Why Would Anyone Use a 1035 Exchange?

Usually the reason why you would use the 1035 exchange is to update the benefits or “riders” of an insurance product.  

What is Section 1035 Exchange

Image Source: What is Section 1035 Exchange?

For example, sometimes, an insurance policy becomes outdated or needs to be revised, at which point it would make financial sense to increase the coverage amount that an updated insurance policy would pay out.  

Another reason to use a 1035 exchange

Another reason for using a 1035 exchange would be to change the insurance company that is providing you with the insurance policy (the insurance underwriter).

Tax Aspect

One of the biggest benefits of purchasing an insurance product like life insurance or an annuity is the tremendous tax advantages offered.

Usually, these strategies are employed after all other qualified accounts, such as 401k, IRA, Roth IRA, etc., have been maxed out.

For example, an annuity could offer the purchaser tax-free growth within the account, much like your standard IRA or 401k.

In other words, you can buy and sell without having to pay anything to Uncle Sam.

Also, like your regular retirement accounts, any early withdrawal before the age of 59 ½ will trigger a tax penalty on top of the income tax owed on any withdrawal.

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