What Is a 1035 Exchange for Life Insurance?

Financial planning often involves making adjustments to existing assets to better suit evolving needs and objectives. Certain financial products, such as life insurance policies and annuities, offer features like tax-deferred growth, meaning investment gains are not taxed until withdrawn. This tax-deferred status allows investments to grow more rapidly without annual taxation. When circumstances change, a specific U.S. tax law provision allows individuals to modify their insurance or annuity portfolios without immediately incurring taxes.

Understanding the 1035 Exchange

A 1035 exchange is a provision within the Internal Revenue Code that permits the tax-free transfer of cash value from one eligible life insurance policy or annuity contract to another. This mechanism allows policyholders to replace an existing contract with a new one of a similar type without triggering immediate taxation on accumulated gains. The exchange provides flexibility in financial planning, enabling individuals to adapt their financial products to changing life circumstances, market conditions, or product offerings, all while preserving the tax-deferred status of their investment.

If a policy has grown in value, the policyholder can move that value to a new contract without realizing the gain and without paying income tax at the time of transfer. Without this exchange, surrendering a policy with accumulated gains would result in those gains being taxed as ordinary income. The 1035 exchange defers the recognition of these gains, allowing them to continue to grow tax-deferred in the new policy.

Permitted Exchanges and Qualifying Rules

Internal Revenue Code Section 1035 specifies the types of contracts that qualify for a tax-free exchange. The exchange must be between “like-kind” contracts or fall within specific IRS-permitted categories.

A life insurance policy can be exchanged for another life insurance policy, an annuity contract, or a qualified long-term care insurance contract. An annuity contract can be exchanged for another annuity contract or a qualified long-term care insurance contract. An endowment contract can be exchanged for another endowment contract (provided the maturity date is not later than the original), an annuity, or a qualified long-term care policy. An annuity contract generally cannot be exchanged for a life insurance policy, as this would allow tax-deferred annuity gains to potentially become tax-free death benefits.

For an exchange to qualify under this section, certain rules must be followed. A primary requirement is the “direct transfer” rule, meaning funds from the old policy must be transferred directly from the old insurance company to the new insurance company without the policyholder taking constructive receipt of the funds. If the policyholder receives the funds, even temporarily, the transaction could be considered a taxable distribution.

Another rule is that the owner and the insured or annuitant must remain the same on both the old and new contracts. This ensures continuity of the underlying financial interest. While multiple contracts can sometimes be consolidated into a single new contract, a single contract cannot be split into multiple new contracts in a 1035 exchange.

Tax Considerations

A benefit of a 1035 exchange is the preservation of the original policy’s cost basis. The cost basis, which is the total amount of premiums paid into the contract less any tax-free distributions, carries over to the new policy. This carryover ensures that accumulated gains continue to defer taxation. For example, if a policy purchased for $50,000 has grown to $70,000, the $50,000 cost basis transfers to the new policy, and the $20,000 gain remains untaxed until a future distribution.

However, certain situations can lead to a taxable event during an otherwise tax-free exchange. This occurs if “boot” is received, which refers to cash or other non-like-kind property received by the policyholder as part of the exchange. If boot is received, the gain recognized and taxed to the policy owner will be the lesser of the amount of boot received or the total gain in the policy.

Policy loans also introduce tax complexities. If an outstanding policy loan is extinguished as part of the exchange, the amount of the loan repaid can be considered taxable boot to the extent of the gain in the policy. To avoid this, a policyholder may pay off the loan with outside funds before the exchange, or the loan might be carried over to the new policy if the new insurer allows it. If a loan is carried over, the exchange can remain tax-free.

Even when an exchange is tax-free, future withdrawals or distributions from the new policy remain subject to standard income tax rules. Gains inside the new policy will be taxed as ordinary income upon withdrawal. If a life insurance policy with a cash value gain is exchanged for an annuity, subsequent withdrawals from the annuity would be taxed on a “last-in, first-out” (LIFO) basis, meaning gains are taxed first.

The Exchange Process

Initiating a 1035 exchange requires careful attention to detail and coordination between the policyholder and both insurance companies involved. The first step involves gathering information about the existing policy, including the policy number, current cash value, any outstanding loans, and details of the original issuing carrier. Simultaneously, the policyholder should determine the desired characteristics of the new policy, such as the carrier, specific policy type, and beneficiary designations. This preparatory phase helps ensure the new policy aligns with current financial goals.

Once the decision to proceed is made, the new insurance company facilitates the exchange process. They provide the necessary forms, which often include a 1035 exchange request form and a new policy application. The policyholder must accurately complete these forms, providing all requested personal and policy-specific details. Ensure the ownership details on the new application precisely match those on file with the old carrier to prevent delays or complications.

After the forms are completed, the new carrier submits the 1035 exchange request to the old carrier. The new carrier requests the direct transfer of funds from the old policy to the new one. The old carrier then processes the request, surrendering the old policy and transferring its cash value directly to the new insurer. This direct transfer maintains the tax-free status of the exchange.

The policyholder will receive communication and documentation from both companies confirming the completion of the transfer, including any necessary tax forms like Form 1099-R, which will indicate a non-taxable event if the exchange was properly executed. The entire process can take several weeks to a few months to finalize.