What Is a 1035 Life Insurance Exchange?
Learn how a 1035 exchange lets you replace a life insurance or annuity policy, transferring its accumulated value to a new contract without triggering taxes.
A 1035 exchange refers to a provision within Section 1035 of the Internal Revenue Code. This regulation permits a policyholder to transfer funds from an existing life insurance policy, endowment, or annuity into a new one without creating an immediate tax liability on the accumulated investment gains. The purpose is to allow individuals to replace older policies with newer ones that may offer better features, lower costs, or more suitable benefits. This exchange helps update insurance coverage for changing financial needs without the tax consequences of surrendering a policy.
Permitted Types of Exchanges
The tax code specifies certain “like-kind” exchanges that are permitted to receive tax-free treatment. A common exchange involves moving funds from one life insurance policy to another, allowing a policyholder to acquire a new policy with a more favorable death benefit or lower premiums. Other permitted transfers include:
- A life insurance policy to an endowment contract.
- A life insurance policy to a non-qualified annuity, a choice for those shifting focus from death benefit protection to retirement income.
- A life insurance policy or a non-qualified annuity to a qualified long-term care insurance policy.
- An existing endowment to a new endowment contract or a non-qualified annuity.
- One non-qualified annuity for another, often to secure better terms or investment options.
Certain exchanges are disallowed and will trigger tax consequences. An annuity contract cannot be exchanged for a life insurance policy. This transaction is not considered a “like-kind” exchange by the IRS, and any gains within the annuity would become taxable as ordinary income.
Qualifying Rules for a Tax-Free Exchange
For an exchange to qualify for tax-free status, several rules must be followed. The policyholder and the insured individual on the new policy must be identical to the policyholder and insured on the original policy. For instance, if a father owns a policy on his daughter’s life, he must remain the owner of the new policy, and his daughter must remain the insured.
A primary rule is that funds must be transferred directly between the insurance companies. The policyholder cannot personally receive the cash value from the old policy to then purchase the new one, an action known as “constructive receipt.” If the policyholder takes possession of the funds, the IRS considers the original policy surrendered, and any gain becomes immediately taxable.
The exchange must also be for a contract of equal or greater value to completely avoid taxes. If the policyholder receives any cash or has a loan on the old policy paid off as part of the transaction, that amount is known as “boot.” Any boot received is taxable as ordinary income, up to the total gain in the original contract. For example, if a policy has a cash value of $50,000, a cost basis of $30,000, and an outstanding loan of $5,000, the total gain is $20,000. If the $5,000 loan is extinguished during the exchange, that $5,000 becomes taxable income to the policyholder.
Information and Documentation for the Exchange
Before initiating a 1035 exchange, you must gather specific information about the existing policy. This includes the full policy number, the legal name and mailing address of the insurance company that issued the old policy, and the policy’s current cash surrender value. You will also need to identify any outstanding loan balance, as this impacts the transaction’s tax implications.
The transaction requires completing two primary documents: the application for the new policy and a dedicated 1035 exchange request form provided by the new insurance company. This form formally notifies both companies of your intent to perform a tax-free exchange and authorizes the direct transfer of funds. You will use the gathered policy information to specify the amount to be transferred and how any existing loans should be handled.
The Exchange Process
Once the application and the 1035 exchange form are signed, both documents are submitted to the new insurance company. The new company drives the process and handles all inter-company communication, so you do not need to contact your old insurer. Upon receiving your paperwork, the new company begins its underwriting process and sends the signed exchange form to the old company to request the direct transfer of funds.
The entire process can take several weeks to complete. The new insurer will provide confirmation once they have received the funds from the old policy. Following this confirmation, the new policy is issued and put in force, and the old policy is automatically terminated as part of the completed transfer.