What Is 1035 Exchange?
A tax-free transfer of one life insurance policy, annuity, or endowment contract to another without triggering a taxable event, authorized under Internal Revenue Code Section 1035.
Understanding 1035 Exchange
A 1035 exchange, named after Section 1035 of the Internal Revenue Code, allows a policy owner to transfer the cash value from one life insurance policy, annuity contract, or endowment contract to another similar contract without recognizing a taxable gain at the time of the exchange. This provision enables policy owners to upgrade to a better-performing policy, change coverage types, switch to a carrier with stronger financial ratings, or move to a product with more favorable features, all without the tax consequences that would normally result from surrendering the old policy and purchasing a new one.
The IRS allows the following 1035 exchanges: life insurance to life insurance, life insurance to annuity, annuity to annuity, and endowment to annuity. Notably, an annuity cannot be exchanged for a life insurance policy, as this would be considered moving from a less tax-favored contract to a more tax-favored contract, which the tax code does not permit. The exchange must be a direct transfer between insurance carriers; the policy owner should never take constructive receipt of the funds. If the policy owner receives the cash value and then purchases a new policy, the transaction does not qualify as a 1035 exchange and the gain becomes taxable.
While a 1035 exchange preserves the tax-deferred status of the cash value, there are important considerations that should be evaluated before proceeding. The new policy will have a new surrender charge period, which can limit liquidity for another 10 to 20 years. A new contestability period (typically two years) begins, during which the new carrier can investigate and potentially contest claims. A new suicide exclusion period also begins. Any existing loans on the old policy may need to be repaid before the exchange or may be treated as taxable "boot" in the exchange. The cost basis carries over from the old policy to the new policy.
Policy owners should carefully evaluate whether the benefits of the new policy justify the reset of these protective periods and any new charges. The decision should be based on a thorough comparison of the old and new policies, including death benefit, cash value projections, charges, rider availability, and carrier financial strength. A licensed agent in our network can facilitate this comparison and help determine whether a 1035 exchange is in your best interest.
Important Things to Know
A 1035 exchange allows tax-free transfer of cash value between qualifying insurance contracts, preserving the tax-deferred status of the funds.
Permitted exchanges: life-to-life, life-to-annuity, annuity-to-annuity, endowment-to-annuity; annuity-to-life is not permitted.
The transfer must be direct between carriers; the policy owner must not take constructive receipt of the funds, or the gain becomes taxable.
The new policy will have new surrender charges, a new contestability period, and a new suicide exclusion period.
Outstanding loans on the old policy may need to be repaid or may be treated as taxable "boot" in the exchange.
The cost basis from the old policy carries over to the new policy, preserving the tax-free recovery of premiums paid.
Tennessee replacement regulations require agents to complete disclosure forms and provide a comparison of old and new policies.
A thorough comparison of both policies should be conducted before proceeding, including death benefit, charges, cash value projections, and carrier strength.
Seeing 1035 Exchange in Practice
Illustrative example: A 60-year-old Knoxville resident has a universal life policy with $180,000 in cash value (cost basis of $120,000) that is underperforming due to low credited interest rates and rising cost of insurance charges. They execute a 1035 exchange to transfer the full $180,000 into a new IUL policy with a carrier offering more competitive cap rates and a no-lapse guarantee rider. The $60,000 gain is not taxed at the time of the exchange. The cost basis of $120,000 carries over to the new policy. The new policy has a new 15-year surrender charge schedule and a new two-year contestability period. This example is illustrative only; actual exchange terms vary by carrier and policy. In a second illustrative scenario, a 65-year-old Nashville resident who no longer needs life insurance coverage exchanges her whole life policy with $250,000 in cash value for an annuity contract through a 1035 exchange. The full $250,000 transfers tax-free, and she begins receiving annuity payments in retirement. Without the 1035 exchange, surrendering the whole life policy would have triggered a taxable gain of approximately $100,000. Actual exchange terms, annuity rates, and tax implications vary by carrier and individual circumstances.
1035 Exchange in Tennessee
Tennessee has no state income tax, which means the tax deferral benefits of a 1035 exchange are evaluated solely at the federal level for Tennessee residents. However, the federal tax savings from deferring gain on the exchange can be substantial, making the 1035 exchange a valuable planning tool. The TDCI oversees 1035 exchanges conducted in Tennessee to ensure that the replacement policy is suitable and that consumers are not disadvantaged by the exchange. Under Tennessee replacement regulations (TCA Title 56, TDCI rules), agents must complete a replacement disclosure form and provide a detailed comparison of the old and new policies, including death benefit, cash value, charges, surrender periods, and carrier financial strength. This consumer protection ensures that 1035 exchanges are conducted in the policy owner's interest and that the benefits of the new policy justify the costs and resets involved. Agents in our network can guide Tennessee residents through the 1035 exchange process, including coordinating with both carriers, managing the paperwork, and ensuring the exchange is executed as a direct transfer.
Explore 1035 Exchange in Detail
Get answers to specific questions about 1035 exchange.
Related Glossary Terms
Surrender Value
The amount a policy owner receives if they voluntarily terminate a permanent life insurance policy before its maturity or before the insured's death.
Read Definition →Cash Value
The savings component of a permanent life insurance policy that accumulates on a tax-deferred basis and can be accessed by the policy owner during their lifetime.
Read Definition →Modified Endowment Contract (MEC)
A life insurance policy that has been funded with premiums exceeding federal limits under IRC Section 7702A, resulting in less favorable tax treatment of distributions and loans.
Read Definition →Cost of Insurance
The monthly charge deducted from a universal life or IUL policy's accumulated value to pay for the actual death benefit protection, based on the insured's age, health class, and coverage amount.
Read Definition →Learn More
Frequently Asked Questions About 1035 Exchange
No, a properly executed 1035 exchange does not trigger a taxable event at the time of the transfer. The gain in the old policy is deferred and carries over to the new policy along with the cost basis. However, if there are outstanding loans on the old policy that are not transferred, they may be treated as taxable "boot." Tennessee has no state income tax, so only federal tax rules apply to Tennessee residents.
Yes. The IRS has recognized partial 1035 exchanges in certain circumstances, allowing a portion of the cash value to be transferred to a new policy while the original policy remains in force with reduced value. However, the rules around partial exchanges are complex and not all carriers accept them. Consult with a qualified agent and tax professional before pursuing a partial exchange.
A 1035 exchange typically takes 2 to 8 weeks to complete, depending on the carriers involved, the complexity of the transfer, and whether outstanding loans need to be resolved. During the exchange period, the old policy generally remains in force until the transfer is finalized, so there is no gap in coverage. Your agent can provide a more specific timeline based on the carriers involved.
Compare the death benefit, guaranteed and projected cash value growth, surrender charge schedules, cost of insurance charges, administrative fees, rider availability and costs, carrier financial strength ratings, and the length of the new contestability period. Also consider whether the benefits of the new policy justify the reset of the surrender charge period and any new charges. A licensed agent in our network can facilitate this comparison.
Yes. A life insurance policy can be exchanged for an annuity under Section 1035 on a tax-free basis. This is often done when the policy owner no longer needs the death benefit protection and wants to convert the cash value into retirement income. The reverse exchange (annuity to life insurance) is not permitted under Section 1035.
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