What Is Section 1035 and How Does It Apply to Insurance Policies?

Swapping one insurance policy for another can have tax consequences, but Section 1035 of the Internal Revenue Code allows certain exchanges to occur without triggering immediate taxes. This rule helps policyholders upgrade coverage, adjust investment strategies, or reduce costs while maintaining tax-deferred status.

Which Policies Qualify for 1035 Exchanges

Not all insurance policies qualify, as the IRS has strict guidelines. Eligible policies include life insurance, endowment contracts, and non-qualified annuities. The exchange must be between similar types of policies. A life insurance policy can be exchanged for another life insurance policy, an annuity, or a long-term care policy, but an annuity cannot be exchanged for life insurance.

Qualifying life insurance policies include whole life, universal life, and variable life insurance. Many policyholders use this provision to move from a policy with high fees or poor investment performance to one with better terms. For example, someone with an older whole life policy that has accumulated significant cash value but offers a low interest rate may exchange it for a newer policy with better growth potential. The new policy must be issued to the same insured individual, and ownership must remain the same to maintain tax-deferred status.

Endowment contracts, which pay a lump sum after a set period or upon the policyholder’s death, can also be exchanged. Though less common today, these contracts can be swapped for another endowment contract or an annuity, allowing policyholders to extend tax deferral if their financial goals change.

Annuities qualify for exchanges but only if the transaction is from one annuity to another. Many policyholders use this option to move from an older annuity with high fees or limited investment choices to a newer one with lower costs or enhanced income options. Fixed annuities can be exchanged for variable annuities and vice versa, as long as the transaction remains within the annuity category.

Long-term care insurance can also be acquired through a 1035 exchange, but only if the funds come from a life insurance policy or an annuity. This option allows individuals who no longer need life insurance to use accumulated cash value for future healthcare expenses without triggering immediate tax liability.

Partial Exchange Requirements

A full exchange isn’t always necessary. Policyholders may transfer only part of a contract’s value while keeping the original policy active. This is known as a partial 1035 exchange, and specific IRS rules must be followed to avoid unintended tax consequences.

To qualify as tax-free, the transaction must be a direct transfer between insurance companies. The policyholder cannot receive the funds personally, or the transaction will be treated as a taxable distribution.

Timing is also important. Under IRS Revenue Ruling 2003-76, if a policyholder takes a distribution from either the original or new contract within 12 months of a partial exchange, the entire transaction may be recharacterized as a taxable withdrawal. This rule prevents individuals from using partial exchanges to avoid taxes on policy withdrawals.

The IRS requires that cost basis and earnings be allocated proportionally between the original and new contracts. For example, if an annuity with a $100,000 value and a $60,000 cost basis undergoes a 40% partial exchange, the new contract will inherit a $40,000 value and a $24,000 cost basis. This proportional allocation affects how future withdrawals are taxed under the last-in, first-out (LIFO) rule applicable to annuities.

Tax Accounting Aspects

The tax treatment of a 1035 exchange depends on proper reporting and compliance with IRS regulations. While the transaction itself is tax-deferred, the basis and gain from the original policy carry over to the new one, influencing future tax liability. When distributions eventually occur, they will be taxed based on the original cost basis and any accumulated gains.

Insurance companies report 1035 exchanges using Form 1099-R. In a full exchange, the form typically indicates a non-taxable transfer if all requirements are met. In a partial exchange, reporting is more complex, as the IRS mandates proper allocation of basis and gains between the original and new contracts. Errors in reporting can result in unexpected tax liabilities, especially if a distribution occurs within 12 months, potentially triggering a recharacterization of the exchange as a taxable event.

State tax implications also vary. Some states impose their own regulations regarding the recognition of gains or the treatment of insurance policy exchanges, which can affect state income tax calculations. Policyholders moving to a different state should verify whether their new state has different tax treatment for such transactions.

Documentation and Record-Keeping

Maintaining thorough records is essential when executing a 1035 exchange, as the IRS and state regulators may require proof that the transaction was completed in compliance with tax laws. Proper documentation ensures the exchange is recognized as tax-deferred and helps prevent complications if the IRS audits the taxpayer or if discrepancies arise in reporting.

A well-documented exchange begins with obtaining a transfer request form from the receiving insurance company, which facilitates a direct transfer of funds. This form should be retained alongside the original policy contract and any correspondence from both the surrendering and acquiring insurers confirming the details of the exchange. Keeping these confirmations is important in case any inconsistencies appear in IRS Form 1099-R.

Beyond the basic exchange paperwork, policyholders should maintain a historical record of premium payments, cost basis calculations, and any prior transactions that may affect future tax treatment. This is especially relevant for policies that have undergone multiple exchanges over time, as tracking the original cost basis is necessary to determine taxable gains upon withdrawal or surrender. Tax professionals often recommend keeping these records indefinitely, as insurers may not always provide a complete history of prior exchanges.

Consequences of Non-Compliance

Failing to follow IRS rules when executing a 1035 exchange can lead to unintended tax liabilities and administrative complications. Errors in structuring the transaction, improper documentation, or misreporting can result in the exchange being treated as a taxable event, eliminating the intended tax deferral benefits.

One common mistake is when policyholders take possession of funds from the original policy instead of executing a direct transfer between insurers. If the IRS determines the transaction was a distribution rather than an exchange, the policyholder may owe ordinary income tax on any gains. If they are under age 59½, an additional 10% early withdrawal penalty could apply in the case of annuities. Additionally, if a partial exchange is followed by a withdrawal within 12 months, the entire transaction may be reclassified as taxable.

Inaccurate reporting by the insurance company or policyholder can also create issues. If an insurer incorrectly categorizes the exchange on Form 1099-R, the IRS may assume a taxable distribution occurred, requiring the policyholder to provide documentation proving otherwise. In some cases, policyholders may need to file an amended tax return or work with the insurer to correct the reporting. Given the complexity of these transactions, consulting a tax professional before initiating an exchange can help avoid costly mistakes and ensure compliance with all applicable regulations.