Here's something most people don't realize about their life insurance or annuity: you're not stuck with it forever. If you bought a policy ten years ago and now there are better options with lower fees, improved guarantees, or features that didn't exist back then, you can upgrade—without triggering a massive tax bill. That's exactly what a 1035 exchange does.
Named after Section 1035 of the Internal Revenue Code, this provision allows you to transfer the cash value from one insurance or annuity contract to another similar contract without paying taxes on any gains. It's a powerful tool for optimizing your financial strategy, but only if you follow the IRS rules carefully. One wrong move—like receiving a check instead of doing a direct transfer—and you'll owe taxes on every dollar of growth in your old policy.
What Is a 1035 Exchange?
Think of a 1035 exchange as a tax-protected swap for certain types of insurance products. The IRS allows you to move money between qualifying contracts—life insurance, annuities, endowment policies, and long-term care insurance—without recognizing the gain as taxable income in the year of the exchange. Your investment continues growing tax-deferred in the new policy, just as it did in the old one.
The key benefit? You're not eliminating taxes—you're deferring them. Your original cost basis (the premiums you paid into the old policy) carries over to the new contract. Eventually, when you take withdrawals or the policy pays out, you'll pay taxes on the growth. But in the meantime, your money keeps compounding without the drag of immediate taxation.
Recent data shows approximately 18% of permanent life insurance policyholders have used a 1035 exchange in the past decade, with activity increasing 23% between 2022 and 2024. The average cash value transfer has grown from $78,500 in 2023 to $92,700 in early 2025, reflecting both higher policy values and greater awareness of this strategy.
The Rules You Must Follow
The IRS is very specific about how 1035 exchanges must be structured. Break these rules, and you'll lose the tax-free treatment:
Direct transfer is mandatory. The money must move directly from your old insurance company to your new one. You cannot receive a check, deposit it, and then buy a new policy—even if you do it the same day. The moment you have constructive receipt of those funds, the IRS considers it a taxable distribution. Both insurance companies need to know upfront that you're doing a 1035 exchange.
Same owner, same insured. The owner and insured person (or annuitant for annuities) must be identical on both the old and new contracts. You can't transfer a policy from yourself to your spouse, your kids, or anyone else. If ownership changes, the exchange is disqualified and becomes taxable.
Know what you can exchange. The IRS allows life insurance to life insurance, life insurance to annuity, life insurance to long-term care insurance, and annuity to annuity. But you cannot move from an annuity back into life insurance. The rule is essentially one-way: you can move toward retirement income products (annuities) but not backward toward death benefit products (life insurance).
Handle loans carefully. If your old policy has an outstanding loan, things get tricky. If the loan is discharged as part of the exchange, you may owe taxes on the gain in the contract. If the loan carries over to the new policy, the exchange remains tax-free, but your new policy starts with debt already attached. Either way, consult a tax professional before proceeding.
When Should You Use a 1035 Exchange?
Not every situation calls for a 1035 exchange. Here are the scenarios where it makes the most sense:
Better features are available. Insurance products evolve. Policies issued today often have features that didn't exist five or ten years ago—chronic illness riders, no-lapse guarantees, improved withdrawal options, or better death benefit guarantees. If your current policy feels outdated, a 1035 exchange lets you upgrade without restarting the tax clock.
Lower costs. Some newer policies have significantly lower internal fees and expense ratios. Over time, these savings compound. If you can move to a policy with better pricing while keeping the same coverage, it's worth considering.
Your needs have changed. Maybe you bought a life insurance policy decades ago, but now you're more interested in guaranteed retirement income. You can use a 1035 exchange to convert that life insurance cash value into an annuity that provides lifetime income payments. Or perhaps you're now concerned about long-term care costs and want to redirect those dollars into a policy that covers nursing home or home health care.
You're consolidating policies. If you have multiple small annuities or life insurance policies scattered across different companies, a 1035 exchange lets you consolidate them into one contract. This simplifies your financial life and often reduces fees.
Common Mistakes to Avoid
Even though a 1035 exchange sounds straightforward, people make costly errors. Here's what to watch out for:
Ignoring surrender charges. Your existing policy may have surrender charges if you haven't held it long enough. These fees can eat into your cash value significantly. Before initiating an exchange, calculate whether the surrender charges outweigh the benefits of the new policy. Sometimes it makes sense to wait until the surrender period expires.
Not comparing the new policy carefully. Just because a policy is newer doesn't mean it's better for you. Compare the fees, guarantees, and features side by side. Some new policies come with higher ongoing costs or less favorable terms than your existing coverage.
Messing up the paperwork. Common form errors include incorrect policy numbers, mismatched Social Security numbers, wrong plan types, or forgetting to indicate partial exchange amounts. Double-check everything before submitting. Both your old and new insurance companies need to process the forms correctly, or you risk delays—or worse, accidental taxable distributions.
Forgetting about tax reporting. Even though the exchange itself is tax-free, it's still reportable. You'll receive IRS Form 1099-R from the company you're leaving, showing the exchange. Make sure the form is correct and include it with your tax return. Missing this step can trigger IRS inquiries.
How to Get Started with a 1035 Exchange
If you think a 1035 exchange might benefit you, here's how to approach it:
First, review your current policy thoroughly. Understand what you have—the cash value, death benefit, fees, riders, and any surrender charges. Request an in-force illustration from your current insurance company to see projections of future performance.
Next, shop for a better policy. Work with a financial advisor or insurance agent who can compare options from multiple carriers. Don't just focus on the sales pitch—ask for detailed cost breakdowns, fee schedules, and policy illustrations that match your age and health profile.
Then, consult a tax professional. While 1035 exchanges are generally straightforward, individual circumstances vary. If you have policy loans, complex ownership structures, or significant gains, get personalized tax advice before proceeding.
Finally, initiate the exchange correctly. Work with your new insurance company to complete the proper forms—typically an ACORD 1035 exchange form. Ensure both companies understand this is a 1035 exchange and that funds will transfer directly. Never accept a check payable to you personally.
A 1035 exchange can be an excellent way to optimize your insurance and retirement planning without triggering unnecessary taxes. But it's not something to rush into. Take the time to understand your current coverage, compare your options, and get professional guidance. When done correctly, you'll preserve your tax-deferred growth while upgrading to a policy that better serves your current needs and future goals.
