What Is Not Allowable in a 1035 Exchange?
Understand the critical details that define a valid 1035 exchange to ensure your contract transfer remains a non-taxable event.
A 1035 exchange, from Section 1035 of the Internal Revenue Code, provides a way to replace an existing insurance policy or annuity contract with a new one without immediately owing taxes on the original contract’s gains. This provision allows policyholders to move into products with better features, lower fees, or more suitable investment options as their needs change. Understanding the transactions and conditions that are not permitted is important to avoid unexpected tax consequences.
Prohibited Policy and Contract Swaps
The foundation of a valid 1035 exchange rests on the “like-kind” principle, though the definition is unique to insurance products. The Internal Revenue Code establishes a clear hierarchy for these exchanges. For instance, a life insurance policy can be exchanged for another life insurance policy, an endowment contract, or an annuity. Similarly, an endowment contract can be exchanged for another endowment or an annuity.
A primary prohibition is the exchange of an annuity contract for a life insurance policy. This transaction is disallowed because it would convert a tax-deferred growth vehicle (an annuity) into a product that offers a tax-free death benefit (life insurance), circumventing the intended tax structures for each product. Another disallowed transaction is the exchange of an endowment contract for a life insurance policy. While endowment contracts are less common today, this rule follows the same logic as the annuity-to-life-insurance prohibition.
Changing the Insured or Owner
A requirement for a 1035 exchange is the continuity of the individuals involved in the contract. For an exchange of life insurance policies, the insured person must be the same on both the old and the new policy. Likewise, when exchanging annuity contracts, the annuitant—the person whose life expectancy is used to calculate payments—must remain consistent. A change in the insured or annuitant is treated as the surrender of the original policy and the purchase of a new one, which is a taxable event. For example, a father could not exchange a life insurance policy on himself for a new policy on his daughter under Section 1035.
The identity of the policy owner must also remain the same for the exchange to qualify for tax-free treatment. Transferring ownership from one person to another during the exchange process disqualifies the transaction. For instance, a policy owned by an individual cannot be exchanged for a new policy owned jointly by that individual and their spouse.
Receiving Cash or Other Property
A rule in a 1035 exchange is that the transaction must be a direct transfer of funds from the old insurance company to the new one. The policy owner cannot receive any cash or other non-like-kind property, referred to as “boot,” during the process. If the owner takes possession of the funds, the transaction is no longer a direct exchange and the tax-free status is voided. The receipt of boot does not disqualify the entire exchange, but it does trigger tax consequences.
Any gain in the original contract becomes taxable as ordinary income, up to the amount of boot received. For example, if a contract has a $20,000 gain and the owner receives $5,000 in cash, that $5,000 is taxable. Boot can also be created if an outstanding loan on the old policy is extinguished during the exchange rather than being carried over to the new policy, as the forgiven loan amount is treated as boot. Taking a partial cash withdrawal shortly before an exchange can also be viewed as taxable boot.
Exchanges Involving Qualified or Foreign Contracts
The rules under Section 1035 apply specifically to non-qualified contracts, which are those purchased with after-tax dollars. A 1035 exchange cannot be used to move funds from a qualified annuity, such as one held within an IRA or 401(k), to a non-qualified annuity. The movement of assets between qualified accounts is governed by a different set of rules for rollovers and trustee-to-trustee transfers. This distinction exists because qualified plans are funded with pre-tax money while non-qualified annuities use after-tax money, and mixing these funds is prohibited to maintain their respective tax treatments.
Section 1035 also does not apply to any exchange that transfers property to a person who is not a U.S. person. These rules are designed to keep such transactions within the U.S. regulatory and tax system.