1035 Exchanges

“ What is a 1035 exchange of an annuity contract, and can they apply to a 401(k) plan?”

ERISA consultants at the Retirement Learning Center Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs, qualified retirement plans and other types of retirement savings and income plans, including nonqualified plans, stock options, and Social Security and Medicare. We bring Case of the Week to you to highlight the most relevant topics affecting your business.

A recent call with a financial advisor from Maryland is representative of a common inquiry related to 1035 exchanges of annuity contracts. The advisor asked: “What is a 1035 exchange of an annuity contract, and can they apply to a 401(k) plan?”

Highlights of Discussion

What follows is not tax advice. For specific tax questions, please seek guidance from a tax and/or legal advisor. Generally, in a 1035 exchange, the owner of a “non-qualified” annuity (or life insurance, endowment or qualified long-term care insurance) contract can transfer the existing contract to a new contract, without owing taxes on the amount transferred [IRC § 1035(a) and Treasury Regulation (Treas. Reg.) §1.1035–1 ]. The table below outlines the acceptable exchanges.

The IRS has generally held that 1035 exchanges of annuity contracts are only available for non-qualified contracts (i.e., those not held within an IRA or qualified retirement plan). IRC §1035(a) does not apply to qualified annuities like those held by IRAs, 401(k)s or 403(b)s due, in part, to the special rollover and transfer rules applicable to qualified arrangements (see Private Letter Rulings 9241007 and 9233054, and General Counsel Memorandum 39882).

Conclusion

A 1035 exchange is a tax-free swap of certain non-qualified insurance contracts for another contract under IRC §1035(a). Contracts held in qualified arrangements such as IRAs and 401(k) plans would not qualify for a 1035 exchange. Please seek tax and/or legal advice for specific cases.