A 1035 exchange is a transfer of one life insurance policy or annuity contract directly to another, institution to institution, under Section 1035 of the Internal Revenue Code, so that the gain in the old contract is not taxed at the time of the move. The money never passes through your hands. I am Paul Rodriguez, a licensed insurance producer, and I use 1035 exchanges when a client has an old policy or annuity that no longer fits — and I turn them down when the exchange is really a sales trick.
What a 1035 exchange allows
The IRS permits a tax-free exchange in these directions:
- Life insurance → life insurance
- Life insurance → annuity
- Annuity → annuity
- Life insurance or annuity → long-term care contract (with conditions)
It does not allow annuity → life insurance. Going that direction is a taxable surrender of the annuity followed by a new purchase.
The owner and the insured (or annuitant) must be the same on both contracts. You cannot 1035 a policy on your life into a policy on your spouse's life.
Why it matters: cost basis carries over
Say you bought a whole life policy 15 years ago, paid $60,000 in premiums, and it now has $90,000 of cash value. If you surrender it, the $30,000 gain is ordinary income that year. If you 1035-exchange it into a new policy, the $30,000 gain moves with it untaxed, and the new policy's cost basis is $60,000. The same applies to an annuity: an old contract with $100,000 of gain can move to a new carrier with no tax event.
The other direction matters too. If the old policy has a loss — basis higher than cash value — that loss also carries into the new contract, which can shelter future gain.
When I recommend one
An old annuity coming out of its surrender period with a cap or rate that is no longer competitive. A 1035 to a new contract resets the terms; it also resets the surrender period, which is the trade.
An old universal life policy that is underfunded and heading toward lapse. Sometimes exchanging the cash value into a new policy with a guaranteed death benefit, or into an annuity, salvages something before the charges eat the rest.
A policy from a carrier whose ratings have dropped. Moving to a stronger insurer without triggering tax.
A whole life policy the client no longer wants as insurance, exchanged into an annuity for income. The gain stays deferred and the client stops paying premiums.
When I refuse
The 1035 exchange is the most abused transaction in this business, because it lets an agent write a new policy on money that is already placed. Every exchange starts a new surrender period and, for life insurance, a new set of acquisition charges and a new contestability period. So:
- If the old contract is still in its surrender period, the surrender charge comes out before the exchange. The new contract has to be better by more than that charge, plus the cost of a new surrender period. It rarely is.
- If the old policy has a guaranteed interest rate or a death-benefit guarantee that new products do not match, the exchange gives that up.
- If the old policy has an outstanding loan, the loan is generally treated as a distribution at exchange and the gain up to that amount is taxable. The loan has to be dealt with first.
- If the only reason for the exchange is that an agent gets paid again, it is a replacement, and most states require a replacement form that says so.
I tell clients what I tell my own agents: a 1035 is a tool for fixing a contract that is wrong for you now. It is not a reason to churn one that is fine.
Partial 1035 exchanges
You can exchange part of an annuity into a new annuity. The basis is split pro rata between the two contracts. The IRS treats withdrawals from either contract within 180 days of a partial exchange as if they came from the original, which can make them taxable — so a partial exchange is not a way to pull money out tax-free.
How the process works
1. Apply for the new contract with the new carrier.
2. Sign the carrier's 1035 exchange form (often the ACORD form) and the state replacement form.
3. The new carrier requests the funds from the old carrier. You do not receive a check. If you do receive a check, the exchange has failed and the gain is taxable.
4. The old carrier liquidates and transfers. Two to six weeks is typical; old carriers are not in a hurry.
5. The new contract is issued with the old basis attached. You will receive a 1099-R from the old carrier showing the exchange with distribution code 6 — it is informational, not taxable income.
1035 vs rollover vs transfer
A 1035 exchange is for non-qualified contracts — policies and annuities bought with after-tax money. Money in a 401(k) or IRA moves by rollover or trustee-to-trustee transfer, not by 1035. If you are moving a 401(k) into an annuity, that is a direct rollover into a qualified annuity, and the tax deferral comes from the retirement-plan rules, not Section 1035. People use the terms interchangeably on the phone; the paperwork is different.
What to ask before you sign one
What is the surrender charge on the old contract today? In dollars.
What guarantees am I giving up? Rate, death benefit, income base.
Is there a loan on the old policy? Resolve it first.
What is the new surrender period, and the new cap or rate? Compare against the old one after the charge.
Why now? If the honest answer is only "a better product," ask what makes it better in your situation.
Disclosures: Section 1035 is federal tax law and may change; state replacement rules vary. An exchange starts a new surrender period and may involve new charges and a new contestability period. Outstanding policy loans may be taxable at exchange. This page is educational and is not tax or legal advice; consult a tax professional before any exchange.
What is a 1035 exchange? +
A 1035 exchange is a direct, institution-to-institution transfer of a life insurance policy or annuity into another policy or annuity under Section 1035 of the Internal Revenue Code, so the gain in the old contract is not taxed at the time of the move. The money never passes through your hands.
What are the 1035 exchange rules? +
Allowed: life insurance to life insurance, life insurance to annuity, annuity to annuity, and either to a qualifying long-term care contract. Not allowed: annuity to life insurance. The owner and insured or annuitant must be the same on both contracts, and funds must move directly between carriers.
Can I 1035 exchange an annuity to life insurance? +
No. Annuity to life insurance is not a permitted 1035 exchange. Doing it means surrendering the annuity, paying tax on the gain, and buying the policy with after-tax money.
Is a 1035 exchange taxable? +
Not at the time of exchange if done correctly. The old contract's cost basis carries into the new one. Exceptions: an outstanding policy loan is generally treated as a distribution at exchange, and receiving the funds yourself instead of a direct transfer makes the gain taxable.
Is a 1035 exchange the same as a 401(k) rollover? +
No. Section 1035 applies to non-qualified policies and annuities bought with after-tax money. Money in a 401(k) or IRA moves by direct rollover or trustee-to-trustee transfer under retirement-plan rules. The paperwork is different.
When should I not do a 1035 exchange? +
When the old contract is still in its surrender period, when it carries a guaranteed rate or death benefit the new product does not match, when there is an unresolved policy loan, or when the only reason is that an agent gets paid again. Every exchange starts a new surrender period.