Section 1035 Exchange

What Section 1035(a) Provides

Section 1035(a), titled General rules, provides that no gain or loss shall be recognized on the exchange of the contracts described in its four paragraphs.

Under paragraph (1), 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.

Under paragraph (2), no gain or loss shall be recognized on the exchange of a contract of endowment insurance for another contract of endowment insurance which provides for regular payments beginning at a date not later than the date payments would have begun under the contract exchanged, or for an annuity contract, or for a qualified long-term care insurance contract.

Under paragraph (3), no gain or loss shall be recognized on the exchange of an annuity contract for an annuity contract or for a qualified long-term care insurance contract.

Under paragraph (4), no gain or loss shall be recognized on the exchange of a qualified long-term care insurance contract for a qualified long-term care insurance contract.

The Definitions in Section 1035(b)

Section 1035(b), titled Definitions, sets out three definitions for the purpose of the section.

Section 1035(b)(1) provides that a contract of endowment insurance is a contract with an insurance company which depends in part on the life expectancy of the insured, but which may be payable in full in a single payment during his life.

Section 1035(b)(2) provides that an annuity contract is a contract to which paragraph (1) applies but which may be payable during the life of the annuitant only in installments. For purposes of that sentence, a contract shall not fail to be treated as an annuity contract solely because a qualified long-term care insurance contract is a part of or a rider on such contract.

Section 1035(b)(3) provides that a contract of life insurance is a contract to which paragraph (1) applies but which is not ordinarily payable in full during the life of the insured. For purposes of that sentence, a contract shall not fail to be treated as a life insurance contract solely because a qualified long-term care insurance contract is a part of or a rider on such contract.

Exchanges Involving Foreign Persons

Section 1035(c), titled Exchanges involving foreign persons, provides that, to the extent provided in regulations, subsection (a) shall not apply to any exchange having the effect of transferring property to any person other than a United States person.

Cross References to Section 1031

Section 1035(d), titled Cross references, contains two cross references. Under paragraph (1), for rules relating to recognition of gain or loss where an exchange is not solely in kind, see subsections (b) and (c) of section 1031. Under paragraph (2), for rules relating to the basis of property acquired in an exchange described in subsection (a), see subsection (d) of section 1031.

Section 1031(b), titled Gain from exchanges not solely in kind, provides that if an exchange would be within the provisions of subsection (a), of section 1035(a), of section 1036(a), or of section 1037(a), if it were not for the fact that the property received in exchange consists not only of property permitted by such provisions to be received without the recognition of gain, but also of other property or money, then the gain, if any, to the recipient shall be recognized, but in an amount not in excess of the sum of such money and the fair market value of such other property.

Section 1031(c), titled Loss from exchanges not solely in kind, provides that if an exchange would be within the provisions of subsection (a), of section 1035(a), of section 1036(a), or of section 1037(a), if it were not for the fact that the property received in exchange consists not only of property permitted by such provisions to be received without the recognition of gain or loss, but also of other property or money, then no loss from the exchange shall be recognized.

Section 1031(d), titled Basis, provides that if property was acquired on an exchange described in Section 1031, Section 1035(a), Section 1036(a), or Section 1037(a), then the basis shall be the same as that of the property exchanged, decreased in the amount of any money received by the taxpayer and increased in the amount of gain or decreased in the amount of loss to the taxpayer that was recognized on such exchange.

Under the second sentence of Section 1031(d), if the property so acquired consisted in part of the type of property permitted by that section, Section 1035(a), Section 1036(a), or Section 1037(a), to be received without the recognition of gain or loss, and in part of other property, the basis provided in that subsection shall be allocated between the properties (other than money) received, and for the purpose of the allocation there shall be assigned to such other property an amount equivalent to its fair market value at the date of the exchange.

Under the third sentence of Section 1031(d), for purposes of that section, Section 1035(a), and Section 1036(a), where as part of the consideration to the taxpayer another party to the exchange assumed (as determined under section 357(d)) a liability of the taxpayer, such assumption shall be considered as money received by the taxpayer on the exchange.

The Tax Treatment of an Exchange

An exchange means using the contract value of one annuity to purchase another annuity. If certain tax rules are followed, an exchange of one annuity for another may not trigger a taxable event. Instead, the tax deferral continues under the new contract.

The ability to exchange one variable annuity contract for a new one without paying tax on the income and investment gains earned on the original contract can be a substantial benefit and is often used as a selling point. If an owner is investing in an annuity through a tax-deferred retirement plan, the owner does not get any additional tax deferral. The federal tax rules that apply to annuities can be complicated. Tax laws and tax rates also change over time. In addition, there may be state tax implications.

Surrender Charges and Other Costs

Variable annuities may impose a variety of fees. Fees generally include surrender charges, which are owed if money is withdrawn from the annuity before a specified period; mortality and expense risk charges, which the insurance company charges for the insurance risk it takes under the contract; administrative fees, for recordkeeping and other administrative expenses; underlying fund expenses, relating to the investment options; and charges for special features, such as a stepped-up death benefit or a guaranteed minimum withdrawal benefit.

When exchanging an annuity, the owner may be subject to a surrender charge when exiting the old annuity. Upon exchange, the owner may also be subject to a new surrender charge period associated with the new annuity.

Replacing one variable annuity with another should involve an analysis and comparison of the complex features of each security. Only exchange a contract if the owner determines, after comparing the features, fees, rates, and risks of both contracts, that it is preferable to purchase the new annuity rather than continue to own the existing annuity.

Some financial professionals may have a financial incentive to offer a new annuity in place of the one an owner has, and an owner should be careful if a financial professional suggests an annuity exchange.

When an Exchange May Be Considered

One reason to consider exchanging a variable annuity is that the investment options available in the new variable annuity are better suited to the owner's investment goals and objectives. This will require due diligence. The owner will want to read the fund prospectuses and compare such things as fund strategy, investment risk, diversification and other important factors.

Another factor is cost. The new variable annuity may indeed be less expensive. Determining whether the new contract is indeed less costly may take a conscientious side-by-side analysis to determine, ideally in cooperation with a sales representative.

Finally, various benefits of the new variable annuity may be more robust or better suited to the owner than the existing contract. For instance, the new contract might offer enhanced death and living benefits that will help achieve a financial goal.

When Not to Make an Exchange

Generally, the exchange or replacement of insurance or annuity contracts is not a good idea if the owner is offered bonus or premium payments as a major or primary enticement to make an exchange. A bonus credit is the extra amount an insurance company agrees to add to the value of a contract. While this may sound like a good deal, variable annuities with bonus credits may have higher expenses that offset any gain.

Generally, the exchange or replacement of insurance or annuity contracts is also not a good idea if the owner thinks the owner might need money from the annuity in the short term. Another way of saying this is to know the impact of surrender charges, which can be very expensive if the owner withdraws money early or decides to sell the annuity. The owner should check when surrender charges expire with the current annuity, and consider how comfortable the owner is with a potentially longer surrender period that may come with the new contract. Some variable annuity contracts include a free withdrawal provision, up to a certain percentage, or offer a rider to waive surrender charges, but these are generally not standard features.

Generally, the exchange or replacement of insurance or annuity contracts is also not a good idea if the owner pays higher charges, such as annual fees for the new contract or for new features, or pays for features that the owner does not really need.

An annuity should be exchanged only when the owner determines, after knowing all the facts, that doing so will position the owner better to achieve financial goals. Just because a variable annuity can be exchanged does not mean it should be.

FINRA Rule 2330 and Exchanges

The title of FINRA Rule 2330 is Members' Responsibilities Regarding Deferred Variable Annuities. Rule 2330(a)(1) provides that the rule applies to recommended purchases and exchanges of deferred variable annuities and recommended initial subaccount allocations. It also provides that the rule does not apply to reallocations among subaccounts made or to funds paid after the initial purchase or exchange of a deferred variable annuity.

Rule 2330(b)(1) provides that no member or person associated with a member shall recommend to any customer the purchase or exchange of a deferred variable annuity unless such member or person associated with a member has a reasonable basis to believe the items listed in the paragraph. Under paragraph (b)(1)(A)(iii), one of those items is that the particular deferred variable annuity as a whole, the underlying subaccounts to which funds are allocated at the time of the purchase or exchange of the deferred variable annuity, and riders and similar product enhancements, if any, are suitable, and, in the case of an exchange, the transaction as a whole also is suitable, for the particular customer based on the information required by paragraph (b)(2) of the rule.

Rule 2330(b)(1)(B) provides that, in the case of an exchange of a deferred variable annuity, the exchange also must be consistent with the suitability determination required by paragraph (b)(1)(A) of the rule, taking into consideration three items. Under paragraph (b)(1)(B)(i), the first item is whether the customer would incur a surrender charge, be subject to the commencement of a new surrender period, lose existing benefits, such as death, living, or other contractual benefits, or be subject to increased fees or charges, such as mortality and expense fees, investment advisory fees, or charges for riders and similar product enhancements. Under paragraph (b)(1)(B)(ii), the second item is whether the customer would benefit from product enhancements and improvements. Under paragraph (b)(1)(B)(iii), the third item is whether the customer has had another deferred variable annuity exchange within the preceding 36 months.

Rule 2330(c) provides that, prior to transmitting a customer's application for a deferred variable annuity to the issuing insurance company for processing, but no later than seven business days after an office of supervisory jurisdiction of the member receives a complete and correct application package, a registered principal shall review and determine whether he or she approves of the recommended purchase or exchange of the deferred variable annuity.

Rule 2330(d) provides that the member also must implement surveillance procedures to determine if any of the member's associated persons have rates of effecting deferred variable annuity exchanges that raise for review whether such rates of exchanges evidence conduct inconsistent with the applicable provisions of the rule, other applicable FINRA rules, or the federal securities laws, called inappropriate exchanges in the rule, and have policies and procedures reasonably designed to implement corrective measures to address inappropriate exchanges and the conduct of associated persons who engage in inappropriate exchanges.

Supplementary Material .05 to Rule 2330 provides that the rule requires that the member or person associated with a member consider whether the customer has had another deferred variable annuity exchange within the preceding 36 months. Under that provision, a member or person associated with a member must determine whether the customer has had such an exchange at the member and must make reasonable efforts to ascertain whether the customer has had an exchange at any other broker-dealer within the preceding 36 months. An inquiry to the customer as to whether the customer has had an exchange at another broker-dealer within 36 months would constitute a reasonable effort in this context.

The content outline for the Securities Industry Essentials examination lists FINRA Rule 2330, titled Members' Responsibilities Regarding Deferred Variable Annuities, in the FINRA rules list for Section 2, Understanding Products and Their Risks. Candidates should check the current outline before the examination.

Common Misunderstandings

The corrections below come from Section 1035 of the Internal Revenue Code, Section 1031 of the Internal Revenue Code, the Investor.gov page titled Annuities, the FINRA page titled Should You Exchange Your Variable Annuity? and FINRA Rule 2330.

An exchange under Section 1035 is always free of cost. When exchanging an annuity, the owner may be subject to a surrender charge when exiting the old annuity, and upon exchange the owner may also be subject to a new surrender charge period associated with the new annuity.

Tax-free treatment means an exchange is a good idea. Just because a variable annuity can be exchanged does not mean it should be, and an annuity should be exchanged only when the owner determines, after knowing all the facts, that doing so will position the owner better to achieve financial goals.

Any property received in an exchange is free of tax. Section 1031(b) provides that, where the property received in exchange consists not only of property permitted to be received without the recognition of gain but also of other property or money, the gain, if any, to the recipient shall be recognized, but in an amount not in excess of the sum of such money and the fair market value of such other property.

A loss on an exchange can be recognized. Section 1031(c) provides that, where the property received in exchange consists not only of property permitted to be received without the recognition of gain or loss but also of other property or money, no loss from the exchange shall be recognized.

Section 1035 covers only annuities. Section 1035(a) lists exchanges of a contract of life insurance, a contract of endowment insurance, an annuity contract and a qualified long-term care insurance contract.

An exchange of an annuity for any other annuity is always tax-free. If certain tax rules are followed, an exchange of one annuity for another may not trigger a taxable event.

A registered representative may recommend an exchange of a deferred variable annuity without reviewing the customer's recent exchanges. Rule 2330(b)(1)(B)(iii) requires consideration of whether the customer has had another deferred variable annuity exchange within the preceding 36 months.

A recommended exchange needs no principal review. Rule 2330(c) provides that a registered principal shall review and determine whether he or she approves of the recommended purchase or exchange of the deferred variable annuity.

Key Points

Section 1035(a) provides that no gain or loss shall be recognized on the exchanges described in its four paragraphs, which involve contracts of life insurance, contracts of endowment insurance, annuity contracts and qualified long-term care insurance contracts.

An exchange means using the contract value of one annuity to purchase another annuity, and if certain tax rules are followed, an exchange of one annuity for another may not trigger a taxable event.

Section 1031(b) and (c) provide the rules for exchanges not solely in kind, and Section 1031(d) provides the basis rule.

When exchanging an annuity, the owner may be subject to a surrender charge when exiting the old annuity and a new surrender charge period associated with the new annuity.

Rule 2330 applies to recommended purchases and exchanges of deferred variable annuities.

Rule 2330(b)(1)(B)(iii) requires consideration of whether the customer has had another deferred variable annuity exchange within the preceding 36 months.