by John Darer CLU ChFC MSSC CeFT RSP CLTC
What is a 1035 Exchange?
A 1035 exchange is the tax-free exchange of one type of annuity or life insurance contract for another, with the policyholder and insured remaining the same. 1035 Exchange refers to 26 U.S. Code § 1035 - Certain exchanges of 
policies (emphasis added)
Under IRC 1035(a)
No gain or loss shall be recognized on the exchange of—
(1) 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;
(2)a contract of endowment insurance (A) 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 (B) for an annuity contract, or (C) for a qualified long-term care insurance contract;
(3) an annuity contract for an annuity contract or for a qualified long-term care insurance contract; or
(4) a qualified long-term care insurance contract for a qualified long-term care insurance contract.
Why would the holder of an annuity contract want to do a 1035 Exchange?
Without a 1035 exchange, the holder of a nonqualified annuity contract would owe ordinary income tax on any annual returns from the nonqualified annuity, plus a 10% penalty for those under age 59½ (in addition to any surrender fees) for an early surrender.
Under the 1035 exchange rules, however, the holder can avoid the ordinary income taxes if they find an annuity contract with better terms or if they’re nearing the end of their guaranteed term.
Under the 1035 exchange rules, however, the holder can avoid the ordinary income taxes if they find an annuity contract with better terms or if they’re nearing the end of their guaranteed term.
A 1035 Exchange is Not Eligible Into or Out of an SMA
Secondary Market Annuity is term that shrouds the truth in a veil of expertise, that began to be used by merchants of structured settlement payment rights in the late 2000s, as a marketing hook to capture investors in acquired structured settlement receivables. The term SMA is misleading to consumers because it is not an annuity. No investor in these receivables is buying an annuity. They are not applying for or buying a product from an insurance company.
In fact, when it comes to a structured settlement:
- the original annuitant has no ownership in the annuity contract funding the periodic payment obligation as a qualified funding asset under the Settlement Agreement and Qualified Assignment.
- The owner of that annuity, as set forth in the settlement papers, is the qualified assignment company.
- What is sold/transferred is structured settlement payment rights established under a Settlemnent Agreement.
- This is what the investor is purchasing, not an annuity*, or an insurance product.
*NAIC Statutory Issue Paper No. 160, finalized April 6, 2019
Last updated July 2, 2023
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