Understanding 1035 Exchanges: Tax-Free Insurance and Annuity Transfers

A 1035 exchange, named for Internal Revenue Code section 1035, lets policyholders transfer certain insurance and annuity contracts to like-kind contracts without immediate tax consequences. It’s a tax-deferral tool intended to allow owners to replace outdated or underperforming products while preserving the original contract’s tax basis—provided specific IRS rules are followed.

What qualifies for a 1035 exchange

Permitted, tax-free exchanges include:
* Life insurance → Life insurance
* Endowment → Endowment
* Annuity (non‑qualified) → Annuity (non‑qualified)
* Life insurance or non‑qualified annuity → Certain qualified long‑term care (LTC) contracts (added by the Pension Protection Act of 2006)

Important restrictions:
* A non‑qualified annuity cannot be exchanged into a life insurance policy.
* Ownership and annuitant/policyholder must remain the same on both contracts.
* Transfers between qualified retirement accounts (IRAs, 401(k)s) are not 1035 exchanges.
* The transfer must be direct from the old contract to the new contract; you cannot cash out and repurchase.

How it works (mechanics)

• The original contract’s cost basis generally carries over to the new contract.
• Partial exchanges allocate a proportional portion of the cost basis to the new contract; tax treatment differs from full exchanges.
• If the contract is transferred between companies, the transferring company typically issues Form 1099‑R to report the transaction. Even though the exchange is not taxable, it is reportable on the owner’s tax return. In‑house exchanges (within the same insurer) may not generate a 1099‑R.
• You cannot change the owner/annuitant as part of the exchange; doing so can disqualify the tax-free treatment.

Benefits

• Avoid immediate taxation on gains when moving to a more suitable or better-performing product.
• Opportunity to obtain newer policy features, different investment options, or more favorable contract terms without triggering tax on accrued gain.
• Preserve the original cost basis for future tax purposes.

Costs and risks to evaluate

• Surrender charges and contract-specific fees often still apply; insurers do not always waive them for 1035 exchanges (though some companies waive fees for in-company exchanges).
• New policy may impose a new surrender period, higher ongoing fees, or different investment risks.
• You may lose benefits or riders from the old policy (e.g., guaranteed insurability, enhanced death benefits).
• Administrative and transaction costs and any differences in insurer financial strength or guarantees.
• Complexities with partial exchanges—verify how cost basis and gain recognition are handled.

Practical checklist before you exchange

• Confirm the exchange type is allowed under IRC §1035.
• Verify owner and annuitant will remain identical on the new contract.
• Ask the insurer about surrender charges, fee waivers, and whether a 1099‑R will be issued.
• Compare features, fees, riders, and surrender periods of old vs. new contracts.
• Consider lost guarantees or benefits from the old contract.
• Run a cost‑benefit analysis taking into account taxes saved now versus fees and long‑term effects.
• Consult a tax advisor or insurance professional if gains, basis allocation, or ownership issues are unclear.

Example

Jane owns a non‑qualified annuity purchased for $100,000 (her cost basis) that has declined in value to $75,000. She uses a 1035 exchange to move the contract to a new annuity. Her original $100,000 cost basis transfers to the new annuity even though only $75,000 value was moved; she defers tax on any prior gain until a taxable distribution occurs later.

What is not allowed

• Converting a non‑qualified annuity into life insurance (taxable).
• Changing the owner or annuitant as part of the transfer.
• Treating transfers between qualified retirement accounts (IRAs, 401(k)s) as 1035 exchanges.

Replacement vs. 1035 exchange

All 1035 exchanges are replacements, but not all replacements qualify for 1035 treatment. If a replacement does not meet the §1035 rules (for example, an annuity converted to life insurance), it will be a taxable transaction.

Bottom line

A 1035 exchange can be a useful way to move between like-kind insurance and annuity contracts without triggering immediate tax on gains. But tax deferral isn’t the only consideration: fees, surrender charges, lost benefits, and the new contract’s terms can outweigh the benefits. Carefully verify eligibility, compare contracts, and consult a tax or insurance professional before proceeding.