Tax-Free 1035 Exchanges Quick Reference Guide

1035 Exchanges tax free benefits

1035 Exchanges offer tax free benefits

The Pension Protection Act of 2006 (which took effect beginning in 2010) enables individuals to take advantage of special provisions that provide for tax-favored long term care insurance payments.

IMPORTANT DISCLAIMERS:   Please note that the American Association for Long-Term Care Insurance does NOT offer tax or legal advice.  The information on this website is intended for informational purposes and we advise consulting with an accountant or tax professional.

In addition, it is important to understand that NOT all long term care insurance  companies accept 1035 exchanges.  That coupled with the fact that insurance policies offering potential long-term care benefits can vary significantly from one insurance company to another, is the reason we strongly suggest you call the Association to connect with a designated 1035 exchange specialist who can answer your questions without cost or obligation. Call our offices at (818) 597-3227.

Benefits of a 1035 Exchange
A 1035 exchange defers the internal build up of gains associated with the life insurance or annuity policy. Because of the tax-free nature of long term care insurance, the 1035 exchange effectively ensures that the taxable gain disappears entirely.

As a result, individuals with an existing life insurance or annuity policy with a gain may wish to complete a 1035 exchange. Actually, a partial 1035 exchange is more common. This involves using the 1035 exchange to pay the annual long term care insurance premium and, as a result, gaining a more preferable tax treatment for funding their LTC coverage.

Technical Rules
The Pension Protection Act of 2006 altered the Section 1035 rules to allow traditional annuity and insurance policies to be exchanged on a tax-deferred basis for the newly approved long term care hybrid (life insurance or annuity) policies.

In addition, the Pension Protection Act authorized another new form of 1035 exchange. This permits exchanges from a life insurance or annuity policy to a standalone, traditional long term care insurance policy.

Under the new rules of Internal Revenue Code Section 1035(a) (as established by Section 844(b) of the Pension Protection Act), individuals can complete a “like-kind” exchange from an insurance or annuity policy directly to a qualified long-term care insurance policy. The new law stipulates that the long term care insurance policy must be a “tax qualified” policy as defined under IRC Section 7702B. Today, the vast majority of policies meet these criteria. The rules also stipulate that the annuity policy must be non-qualified annuity. These are generally defined as annuities purchased with after-tax funds (as opposed to IRAs or retirement annuities that are purchased with pre-tax dollars).

In order to receive the tax-deferred treatment on the exchange, all the standard requirements of the 1035 exchange must be honored. The most significant requirement stipulates that the amounts must be assigned directly from the old life insurance or annuity policy directly to the new long term care insurance company issuing the policy. If the funds are distributed to the policy owner, they are deemed by the IRS as irrevocably distributed and the normal taxation rules apply.

To obtain the favorable tax treatment of a 1035 exchange, the company issuing the new long term care insurance policy must be willing and able to obtain the funds directly from the prior life insurance or annuity company in accordance with the rules of a proper 1035 exchange.

The Association has a growing list of knowledgeable and independent insurance professionals (brokers) who can help consumers interested in discussing a 1035 exchange.  The best way to start is to call our offices at (818) 597-3227 or to Email us using the Contact form.

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