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1035 exchanges: swapping policies without tax

Section 1035 lets you swap a life policy for another policy or an annuity without taxing the gain. What qualifies, what you can lose and how to do one right.

4LifeInsurance · Published October 4, 2026

A 1035 exchange lets you move the value of an existing life insurance policy into a new life insurance policy, an annuity, or a qualified long-term care contract without paying income tax on the gain. It is authorized by 26 U.S.C. §1035. Done as a direct transfer from one insurer to another, it defers the tax; done as a surrender followed by a new purchase, it does not.

What can be exchanged for what

Section 1035(a) lists the permitted swaps:

From To Allowed?
Life insurance policy Another life insurance policy on the same insured Yes
Life insurance policy Endowment, annuity contract or qualified long-term care contract Yes
Endowment Annuity or qualified long-term care contract Yes
Annuity Another annuity or qualified long-term care contract Yes
Annuity Life insurance policy No

The direction matters: life to annuity is permitted, but annuity to life insurance is not, as the IRS publication on investment income (Pub 550) and §1035 make clear. The owner and the insured must be the same on both sides, and the exchange must be of whole contracts or, under IRS guidance, a partial exchange that follows Revenue Procedure 2011-38 (for example, moving part of an annuity into another annuity).

Why people do one

  • A better product. An older universal life policy with high charges may be replaced by one with lower costs, or a whole life policy that is no longer needed can be converted to an annuity or a long-term care policy.
  • A different job. A retiree who no longer needs the death benefit can turn the cash value into an income annuity or a long-term care benefit; see life insurance in retirement: keep, cut or cash out and hybrid life and long-term care policies.
  • A stronger insurer or better service. Some owners move because of concerns about the original company, though a rating change alone is rarely a reason to give up old guarantees.
  • Avoiding a taxable surrender. Surrendering a policy with gain creates ordinary income; an exchange defers it. See how cash value is taxed: withdrawals, loans and surrenders.

How the tax works

If the exchange qualifies, you recognize no gain or loss at the time. Your basis, the total premiums you paid, carries over to the new contract, and the tax on the gain is deferred until you take money out.

Taxable "boot" can arise in two ways:

  1. Cash received. If the insurer sends you part of the value as a check, that portion is taxable to the extent of gain.
  2. Loan relief. If the old policy has an outstanding loan and the new contract does not assume it, the loan that disappears is treated as cash you received. A loan can often be carried over, but a carried-over loan can restrict the exchange options, so ask first.

A hypothetical example

The following is hypothetical.

Say Tom paid $50,000 in premiums for a universal life policy that now has a cash surrender value of $90,000. He no longer wants coverage and would like a fixed annuity.

Route Tax result
Surrender the policy and buy an annuity with the check $40,000 of ordinary income this year ($90,000 - $50,000)
Direct 1035 exchange into an annuity No tax now; the annuity carries a $50,000 basis and $40,000 of deferred gain taxed as it is withdrawn

Either way the gain eventually becomes taxable, but the exchange lets him choose when. Annuity payouts follow the rules in how annuities are taxed.

What you can lose

An exchange is a new contract, and a replacement of coverage deserves caution.

  • New contestability and suicide periods. The new life policy usually restarts the two-year the two-year contestability period and suicide clause. A claim in the first two years can be investigated for misstatements on the new application.
  • New underwriting. You will need to qualify medically. If your health has worsened, you may be unable to get the same coverage or may pay far more. Do not cancel the old policy until the new one is approved and issued.
  • Higher cost with age. The new policy is priced at your current age, so premiums are usually higher than on an old policy of the same type.
  • Surrender charges and fees. The old policy may impose surrender charges, and the new one often starts a fresh surrender schedule and has new commissions.
  • Old guarantees. Older policies may have favorable guaranteed interest rates, loan rates, dividend histories or grandfathered features that a new policy will not match.
  • MEC risk. The new policy is tested under the 7-pay rules from scratch, and a large rollover can make it a modified endowment contracts and the 7-pay test. A policy that was already a MEC stays one.
  • Twisting. Agents who push unnecessary replacements to earn commissions are engaged in "twisting" or "churning". See twisting and churning: replacement sales abuses.

States regulate replacements. Under the NAIC replacement model regulation, the replacing insurer must notify the existing one within 5 business days, and buyers get a right to return the new policy, commonly for 30 days. Check your state's rules and your free-look period (see policy replacement).

How to do a 1035 exchange

  1. Get the old policy's numbers. Request the current cash surrender value, outstanding loans, basis, surrender charges and an in-force illustration.
  2. Compare the new contract honestly. Ask for the new contract's costs, guarantees and surrender schedule, and compare them with the old one. The keep, surrender or sell your policy? can help you weigh keeping against changing.
  3. Apply for the new contract first. Complete underwriting, and do not cancel the old policy until the new policy is issued and accepted.
  4. Use the 1035 exchange form. Both companies provide an exchange or transfer form. Name the new contract as the receiving contract and have the money sent directly between insurers. Never take the check yourself.
  5. Confirm the paperwork. The old insurer should report the transfer on Form 1099-R as a non-taxable exchange (typically distribution code 6). Keep the statements showing basis.
  6. Keep the free-look period in mind. Review the new contract within the free-look window, and reverse the exchange if the contract is not what you expected.

Because a mistake can turn a deferred gain into an immediate tax bill, and because the right choice depends on your age, health and goals, ask a tax professional or fee-only adviser to review the exchange before the paperwork goes out.

Key takeaways

  • Section 1035 lets you exchange a life policy for another life policy, an annuity, or a qualified long-term care contract without tax on the gain.
  • You cannot exchange an annuity for a life insurance policy.
  • The transfer must go directly between insurers, and the owner and insured stay the same.
  • Cash received and canceled loans are taxable boot.
  • A new policy restarts the contestability period and requires new underwriting, so do not cancel the old policy until the new one is in force.

Terms used in this guide

Cash value The savings component that builds inside whole life, universal life and other permanent policies, which the owner can borrow against or withdraw. Cost basis For life insurance and annuities, the after-tax money put in (premiums minus tax-free amounts taken out), which sets how much of a payout is taxed. Policy replacement Buying a new life policy or annuity while dropping, surrendering or borrowing heavily against an existing one, a sale states regulate closely. Surrender charge A fee deducted from a policy's or annuity's value if you cancel or withdraw too much in its early years, usually shrinking each year. Incontestability clause A provision that bars the insurer from voiding coverage over application misstatements once it has been in force for two years during the insured's life. Policy loan Money borrowed from an insurer using a permanent policy's cash value as collateral, with no credit check and no required repayment schedule.

Related tools

Keep, surrender or sell your policy? Compares cashing in a policy, selling it in a life settlement, and keeping it, using the return your beneficiaries earn on what you keep putting in.

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