A 1035 exchange from application to confirmed transfer

A 1035 exchange succeeds or fails on the paperwork. The tax law lets you move the value of a life insurance policy into a new life policy, an annuity or a qualified long-term care contract without paying income tax on the gain, but only if the money goes straight from one insurer to the other and the details match. This walkthrough follows a hypothetical exchange from the first records request to the day you confirm that your basis arrived intact.

The steps below describe the usual sequence. Every insurer has its own forms and names for them, and some of the timing depends on underwriting and on your state, so read each company's instructions and ask questions in writing. For the rules on what can be exchanged for what, start with the 1035 exchanges: swapping policies without tax guide.

The case we will follow

The following is hypothetical. Say Lena, 58, owns a universal life policy she bought years ago for a need that has passed. She paid $42,000 in premiums over the years and has no loan, and the cash surrender value is $75,000. She wants to move the value into a fixed annuity for retirement income. A life policy can be exchanged for an annuity, though an annuity cannot be exchanged back into life insurance.

If Lena surrendered the policy and bought the annuity with the check, she would recognize $33,000 of ordinary income ($75,000 − $42,000) that year. If the exchange works, she recognizes nothing now, the annuity carries her $42,000 basis, and the $33,000 of gain is deferred until she takes money out. That deferral is the whole reason for the paperwork.

The eight steps in order

Step 1: Pull the facts from the old policy

Before any application, ask the current insurer for:

1. The current cash surrender value, as of a date.
2. The loan balance, if any, with accrued interest.
3. The surrender charge schedule and what applies today.
4. A statement of your basis, or the premium and dividend history from which you can calculate it. The worksheet in figuring your cost basis in a cash value policy before any withdrawal shows how.
5. Whether the policy is a modified endowment contracts and the 7-pay test.
6. A copy of the policy contract and any riders, so you know what you would be giving up.

Request these in writing and keep them. They are the "before" picture. At the end of the exchange you will compare them with what the two insurers report.

Step 2: Decide what the new contract must do

Write down, before you meet a salesperson, what problem the new contract solves. The most common reasons are an annuity for income, a lower-cost policy, or a long-term care benefit. If you cannot explain the reason in a sentence, pause. A replacement can restart contract clocks and charges, and agents are sometimes paid more for replacing than for advising you to keep what you have. The twisting and churning: replacement sales abuses guide describes the practices regulators watch for.

Run the keep-or-change comparison with your own figures. The keep, surrender or sell your policy? is one way to see the options side by side, and the ten checks before you exchange a policy and when to say no checklist lists the questions to ask before you apply.

Step 3: Apply for the new contract first

Apply for the new policy or annuity before you do anything to the old one. This is the single most important ordering rule.

• For a life insurance policy, you go through underwriting. That may include a health questionnaire, a medical exam, and records requests. If your health has changed since you bought the old policy, the new offer can be worse than you expect, or you can be declined. Until the new contract is issued and in force, the old one must stay alive.
• For an annuity, there is no medical underwriting, but there is a suitability review and often a questionnaire about your finances and goals. See how annuities are taxed for how the annuity side is taxed later.

You will also see a replacement form. Because the new contract replaces an existing one, state rules generally require the agent to list the old policy on a disclosure form and give you a notice. The replacing insurer is typically required to notify the existing insurer, and many states set that deadline in days. The notice exists so that the old company can contact you and so that you can compare the contracts with the old insurer's own illustration. Read it. See the policy replacement entry for the term.

Step 4: Complete the exchange form

The 1035 exchange or transfer request is the heart of the paperwork. The exact form depends on the insurers involved, but it usually contains:

• Your name, as owner, matching the old contract exactly. The owner and the insured on the new contract must match the old one.
• The old contract's number and the old insurer's name and address.
• The new contract's number, if it has been issued, or its application number.
• A clear statement that this is a tax-free exchange under section 1035 of the Internal Revenue Code.
• Instructions about what to transfer: the full contract value, or a stated amount.
• Your signature, sometimes notarized or guaranteed, and sometimes the original policy (or a lost-policy statement if you cannot find it).

Some companies need a form from each side. The new insurer's form usually initiates the request, and the old insurer's own surrender or release paperwork authorizes it. If you are unsure which form is needed, call both and ask the service departments which forms they require. Ask each to confirm in writing that the transaction is coded as a 1035 exchange, not as an ordinary surrender.

Step 5: Make sure the money moves insurer to insurer

The tax-free treatment depends on the money never being in your hands. Do not accept a check made out to you, and do not deposit funds in your bank account on the way. The check or wire should be payable to the new insurer, and the paperwork should say it is a 1035 exchange. If money reaches you, the transaction can look like a surrender followed by a new purchase, and the gain can become taxable that year. The 1035 exchanges: swapping policies without tax guide describes this as the "never take the check yourself" rule.

If a check made out to you arrives by mistake, call the old insurer before you cash it. Do not forward it as though nothing happened without first asking both companies and your tax professional how to handle it.

Step 6: Keep paying the old policy until the new one is in force

Premiums on the old policy still come due while paperwork moves. If the old policy lapses during the exchange, the exchange may fail, you may lose coverage in the gap, and the gain may become taxable. Keep paying until the new insurer confirms in writing that the new contract is issued and the funds have been received. If the premium is due while the exchange is in process, pay it and ask the old insurer how the payment will be treated. Get the answer in writing, because a premium that arrives mid-transfer can be handled in more than one way.

Also remember the free-look period. After the new contract is delivered, you have a limited number of days to review it and return it for a refund, typically 10 to 30 days, and longer in some states and for replacements. If the money has already left the old insurer, a cancellation of the new contract during free look raises its own questions about how to reverse the exchange, so ask both companies how that would work before you rely on it.

Step 7: What to expect on timing

Lena's exchange moves through these stages. The calendar varies widely by company, by whether underwriting is required and by how complete the forms are, so these are stages, not promises.

Underwriting for a life policy is usually the slowest piece. A transfer between insurers is often faster once the paperwork is clean, but it depends on how each company processes it. Ask both for their typical timing, and avoid promising yourself a date.

Step 8: Confirm that the exchange worked

The exchange is not finished when the money leaves. It is finished when you can prove it was tax-free and that your basis moved. Gather four confirmations.

1. A written acknowledgment from the new insurer that it received the funds, that the transaction was a section 1035 exchange, and the date and amount received.
2. A confirmation of basis from the new insurer. Your basis, the total premiums you paid, generally carries over from the old contract to the new one. Ask the new insurer to state the basis it has recorded. For Lena, that should be $42,000. If it shows $75,000 or zero, there is a mistake to correct now, while the paperwork is fresh.
3. The old insurer's tax form. In the year of the exchange, the old insurer reports the transfer on a Form 1099-R sent early the following year. A tax-free exchange is generally reported with a distribution code showing a non-taxable exchange. Check the taxable amount, which should be zero for a clean exchange. If the form shows a taxable distribution, ask the old insurer to correct it before you file.
4. The new contract's documents. Confirm the owner, insured, beneficiary designations, and any riders match what you intended. A beneficiary designation often does not carry over automatically.

Keep these four items with your tax records for as long as you own the new contract and for several years after. The basis information is easy to lose across a long holding period, and you will need it when you take money out.

Common ways the paperwork goes wrong

• A mismatch of owner and insured. If the old contract is owned by one person and the new by another, the transaction may not qualify. Match names and ownership exactly, including a trust's full name.
• A loan that is not addressed. An outstanding loan that is not carried over can be treated as cash received. See exchanging a policy that carries a loan and where the tax bill hides for how the tax shows up.
• An unsigned or incomplete form. The most common cause of delay. Review signatures, dates and any guarantee requirements before you send it.
• Money paid to you. A check payable to the owner breaks the direct-transfer rule. Confirm payee instructions.
• Cancelling the old policy too early. If the new contract is not issued, you may have no coverage at all.
• No record of basis. The new insurer might not record basis unless it is told. Ask.
• A new modified endowment contract. A large transfer into a life policy is tested under the seven-pay rules from the start, and the result can be a modified endowment contracts and the 7-pay test. Ask the insurer to confirm that the new policy will not be one.
• Surrender charges you did not expect. The old policy may apply a surrender charge even in an exchange, and the new contract may start its own schedule. See surrender charge.

What the new contract restarts

An exchange to a new life policy generally starts new clocks. The incontestability clause period usually restarts, so in the first two years the insurer can look back at the application for misstatements. The suicide exclusion may restart as well. For more on this, see replacing a policy resets the contestability clock: what to expect. An exchange into an annuity restarts the annuity's surrender schedule. These are costs of the change that belong in your comparison before you apply.

A pocket checklist for the file

Keep one folder, paper or digital, for the whole exchange and check each item off as it arrives.

• The old insurer's value statement, loan balance and surrender charge schedule, dated before the exchange.
• Your basis worksheet and the premium history it was built from.
• The new application, the replacement disclosure form and any comparison the agent gave you, signed and dated.
• The exchange request forms from both insurers, with copies of what you signed.
• The new insurer's written receipt of funds and its statement of the basis it recorded.
• The new contract, with the owner, insured and beneficiary pages reviewed.
• The old insurer's tax form from early the following year, and a note of the taxable amount it shows.

If one of these never arrives, ask for it. A missing receipt or an unconfirmed basis figure is far easier to fix in the first month than in the year you finally take money out.

Where to go for help

If anything about the exchange confuses you, the right people are a tax professional or fee-only adviser, who can run your basis and your options, and your state insurance department, which handles complaints about replacement practices. Ask an adviser who is not paid on the sale of the new contract if you can. A well-run exchange is mostly routine. A badly run one can turn deferred gain into an immediate tax bill.

Key takeaways

• Apply for the new contract first, and keep the old one alive until the new contract is issued and the insurer confirms it received the funds.
• The money must move directly between insurers; a check made out to you can turn the exchange into a taxable surrender.
• Match owner and insured on both contracts, and ask both companies to code the transaction as a section 1035 exchange.
• Confirm in writing that your basis carried over, and check that the old insurer's tax form shows no taxable amount.
• A new life policy restarts contestability and suicide clocks, and a new annuity restarts its surrender schedule, so count those costs before you begin.