1035 Exchange: What It Is and How It Works

A 1035 exchange is a provision in the U.S. Internal Revenue Code that permits the direct transfer of an existing insurance policy or annuity for a new one without creating a taxable event. This allows policyholders to move into products with better features, lower fees, or more suitable benefits as their financial circumstances change. The purpose of Section 1035 is to let individuals replace outdated contracts while deferring the tax consequences on any gains.

Qualifying Contracts for a 1035 Exchange

To be eligible for a 1035 exchange, the original contract must be one of four specific types. These contracts can accumulate cash value over time, which is the component that grows and is subject to potential taxation upon surrender. The qualifying contracts are:

• Life insurance contracts, which are agreements where an insurer pays a beneficiary a sum of money upon the death of the insured.
• Annuity contracts, which are financial products designed to provide a stream of income, often during retirement.
• Endowment contracts, which are life insurance policies that pay a lump sum after a specific term or upon the death of the insured, whichever comes first.
• Qualified long-term care (QLTC) insurance contracts, which cover the costs of services like nursing home care or in-home assistance.

Permitted Exchange Combinations

Section 1035 specifies which types of contracts can be exchanged to maintain tax-deferred status. A life insurance policy can be exchanged for another life insurance policy, an endowment contract, an annuity, or a QLTC contract. This allows a policyholder to transition from a death-benefit-focused product to one that provides living benefits.

An endowment contract can be exchanged for another endowment contract, an annuity, or a QLTC contract. An annuity contract can be exchanged for another annuity or a QLTC contract, which is a common strategy for individuals seeking an annuity with better investment options or lower fees. A QLTC contract can only be exchanged for another QLTC contract.

Certain exchanges are disallowed. An annuity contract cannot be exchanged for a life insurance policy on a tax-free basis. A requirement for all permitted exchanges is the “same insured” or “same annuitant” rule, meaning the insured individual on the old contract must also be on the new contract.

Tax Implications of the Exchange

A properly executed 1035 exchange is tax-deferred, meaning no immediate gain or loss is recognized for tax purposes. The tax liability on any appreciation within the original contract is postponed until a future taxable event occurs, such as making a withdrawal. This deferral allows the contract’s full value to continue growing in the new product without being reduced by taxes.

The process uses a carryover basis, where the cost basis of the original contract transfers to the new one. For instance, if an individual paid $60,000 into an annuity now valued at $90,000, the cost basis in the new annuity remains $60,000. The $30,000 gain is not taxed at the time of the exchange but will be subject to taxation when withdrawn.

Receiving cash or having a policy loan extinguished during the exchange is known as “boot” and can trigger a taxable event. Any gain in the contract is taxable as ordinary income up to the amount of the boot received. For example, if a contract has a $30,000 gain and the policyholder receives $5,000 in cash during the exchange, that $5,000 is considered taxable income.

The Exchange Process

Executing a 1035 exchange requires following specific steps to ensure compliance. The first step is selecting a new policy or annuity that meets the individual’s financial objectives. This requires comparing features, fees, and the issuing company’s financial strength.

Once a new product is chosen, the policyholder must complete an application for the new contract and sign 1035 exchange documents provided by the new insurance company. These forms authorize the direct transfer of funds from the old insurance company to the new one.

The funds must move directly between the two financial institutions. The policyholder cannot take constructive receipt of the money, meaning the cash value cannot be paid to the individual to then purchase the new policy. This direct “trustee-to-trustee” transfer preserves the tax-deferred status of the transaction.