A 1035 exchange from start to finish: forms, timing and pitfalls

A section 1035 exchange is a direct transfer of the value in one contract to another contract, made between two insurers rather than through your hands, so that the gain in the old contract is not taxed at the moment of the move. It sounds like a single event. In practice it is a sequence of eight or nine steps spread over several weeks, and most of the things that go wrong happen because someone did the steps out of order, most often by cancelling the old policy before the new one exists.

This post walks the whole process in order, for a person moving an older cash value life insurance policy into a new contract. The rules about what can be swapped for what are in 1035 exchanges: swapping policies without tax; this is the working version, with what to gather, what to sign, what to ask at each stage and what a normal timeline looks like. A hypothetical owner, Hal, will carry the example through.

The setting: Hal and his old whole life policy

Say Hal is 67. Thirty years ago he bought a whole life policy. Over the years he paid $64,000 in premiums, and the policy's cash surrender value is now $98,000, so his taxable gain, if he were to surrender it, would be $34,000 ($98,000 minus $64,000). His children are grown, the mortgage is gone, and he no longer needs a death benefit. He wants to put the value to work in a fixed annuity. These numbers are hypothetical.

If Hal surrenders the policy and buys the annuity with the check, he reports $34,000 of ordinary income this year. If he does a qualifying exchange, he reports nothing now; the annuity starts with a $64,000 basis and $34,000 of deferred gain, taxed when he takes it out. The exchange does not eliminate the tax. It controls the timing.

Before you apply

Step 1: Confirm the exchange is the right kind of move

Three tests come first, before any paperwork:

1. The direction is allowed. A life insurance policy can be exchanged for another life policy, an annuity, or a qualified long-term care contract. An annuity can be exchanged for another annuity or a qualified long-term care contract. An annuity cannot be exchanged for a life insurance policy.
2. The people match. The owner and the insured on the old contract must be the same as on the new one. A policy owned by a trust cannot be exchanged into a contract owned by you personally and still qualify.
3. The reason is real. An exchange is a replacement, and replacements are where agents are tempted to earn a commission on a move that does not help the client. The sales abuse is described in twisting and churning: replacement sales abuses. Ask yourself, and ask the person recommending the move, what specifically gets better and what gets worse.

If the reasoning holds, go on. If you are not sure, ten checks before you exchange a policy and when to say no lists the situations where the better answer is to leave things alone.

Step 2: Collect the old policy's numbers

Request the following from the current insurer in writing, and keep copies:

• The current cash surrender value and the total cash value before charges.
• Any surrender charge that would apply today, and when it ends. An exchange is treated like a surrender for the purpose of those charges.
• The outstanding policy loan balance and accrued interest, if any.
• Your cost basis, which the insurer can usually state: total premiums paid, less any untaxed amounts previously withdrawn.
• Whether the policy is a modified endowment contract. A policy that failed the seven-pay test stays a MEC; the rules are in modified endowment contracts and the 7-pay test.
• An how to request and read an in-force illustration showing what the policy is projected to do if you keep it.
• A copy of the policy contract, so that you know what guarantees you would be giving up.

The insurer may take a week or two. Ask for the figures as of a specific date and note that the values will move before the transfer happens.

Step 3: Choose and understand the new contract

Before applying, get the new contract's own paperwork: a sample contract or specimen, a current illustration or disclosure, and a statement of the fees, surrender schedule and any market value adjustment. Compare the two contracts side by side on the same questions:

The keep, surrender or sell your policy? is a way to weigh the three basic choices, and replacing a life insurance policy: when it makes sense covers the longer comparison. Ask for answers in writing, not in a sales conversation.

Applying and signing

Step 4: Apply for the new contract

Apply for the new contract first. For an annuity this is usually a short form with no medical underwriting. For a new life policy or a hybrid life and long-term care contract, expect full underwriting: questions about health, possibly an exam, blood and urine samples, and a records request. That can take several weeks, and the outcome is not guaranteed. If your health has declined, you may be offered a higher rating or declined altogether, which is why you keep the old policy in force until the new one is issued.

Two things happen during the application that you should expect:

• A replacement notice. Most states require the agent to give you a notice explaining that you are replacing existing coverage, to list the existing policies involved, and to send a copy to the current insurer. The notice is meant to protect you; read it. Different states set different timing and wording, so ask the agent which rules apply.
• A side-by-side comparison or illustration that you sign. Treat it as an admission of what you were shown, and keep your copy.

Step 5: Complete the exchange paperwork

The exchange request is usually a separate form, sometimes called a 1035 exchange or transfer form, or a combined "absolute assignment" and transfer request. Both insurers have their own versions. The information it asks for is roughly:

• Owner's name, address, Social Security number or taxpayer ID, and signature.
• The old contract's name, number and insurer.
• The new contract's insurer and application or contract number.
• Your instructions: full exchange or partial; whether any loan should be paid off, carried or ignored; and where the money goes.
• An acknowledgment that the old policy will be surrendered or terminated once the funds are sent.

The most common source of delay is a name mismatch. If the old policy is in "Harold J. Wren" and the new application says "Hal Wren," some processing systems will stop. Use the same legal name, spelling and ownership on every form. Another is the signature: some insurers require signatures to be guaranteed or notarized, and some accept electronic signature while others want wet ink. Ask each one up front.

The check or wire must go insurer to insurer. If a check payable to you arrives at your mailbox, do not deposit it; call the new insurer. A check you receive and then pass along is treated as a surrender followed by a purchase, which is taxable.

Step 6: Leave the old policy in force

This is the step people skip, and it is where the real money can be lost. Do not cancel the old policy, stop its premiums, or tell the old insurer to terminate it ahead of the paperwork. Let the exchange form do that when the funds move. There are three reasons:

1. Underwriting is uncertain. If the new life policy is declined or rated, the old one is still there.
2. The coverage must not lapse in between. The old policy continues to protect your beneficiaries until the transfer completes. If you stopped paying and the insured died during the gap, the claim could be denied.
3. Premiums may fall due while the exchange is in process. Keep paying them. If the insurer waits for the transfer to take them from the cash value, ask in writing.

After the transfer

Step 7: The transfer itself

Once the paperwork is complete and any underwriting is approved, the old insurer calculates the surrender value as of the transfer date, deducts any surrender charge, resolves any loan, and sends the net amount to the new insurer. The new insurer applies it as the first premium or deposit. Timing is variable: expect some days to a few weeks for the funds to move after the old insurer has all its paperwork, and longer if the insurers handle the transfer by mailed check rather than electronically.

Key facts to track at this point:

• The date the old insurer calculates the value. Interest or dividends credited between that date and the next anniversary may be forfeited or prorated, so ask when your value is "locked."
• Any money the old insurer pays to you rather than to the new one. Cash you receive is "boot" and is taxable to the extent of gain. If Hal takes $8,000 as a check, he reports up to $8,000 of income, since his gain ($34,000) exceeds it.
• Whether the policy loan, if any, goes with the exchange. A loan that disappears without being assumed is treated as a distribution; see moving a policy with a loan in a 1035 exchange.

Step 8: Receive the new contract and use the free-look period

The new insurer issues the contract and delivers it. This is where the free-look period begins. The length varies by state and by product, commonly from 10 to 30 days, and is often longer for replacements. Read the contract itself, not just the illustration, against the application and the side-by-side. Check:

• The owner, insured, beneficiary and any contingent beneficiary are correct.
• The guarantees, charges and surrender schedule match what you were shown.
• The first-year value is what the old insurer said it sent.
• The new life policy's contestability period has started; see below.

If the contract is not what you expected, return it within the free-look window. Note one catch: once the old policy has been surrendered and the funds sent, returning the new contract may not restore the old one. A refund may come back as cash that is itself taxable. That is the strongest reason to examine the new contract carefully before it is issued and not afterward.

Step 9: The tax paperwork afterward

The old insurer should report the transfer on Form 1099-R, usually with distribution code 6, which marks a tax-free section 1035 exchange. You file the form with your return, showing the gross amount and zero taxable. Check three things:

• The gross distribution matches the amount that moved.
• The taxable amount is $0, unless you took boot.
• The code is correct. A wrong code can prompt a notice from the IRS.

Keep your own records of the basis. The new contract inherits Hal's $64,000, but the new insurer may not track it as precisely as you can. When you later take money out of the annuity, it generally comes out gains first, taxed as ordinary income, with the 10% additional tax generally applying to gains withdrawn before age 59½ (exceptions exist). A tax professional can review the exchange before and after.

What a realistic timeline looks like

These are ranges, not promises, and each insurer's processing speed differs.

Pitfalls collected in one list

• Cancelling the old policy first. The most expensive error. Leave it in force until the new one is issued and funded.
• Taking the check yourself. Direct insurer-to-insurer movement is what keeps it a 1035 exchange.
• Overlooking a loan. A loan that is forgiven in the exchange can create a taxable amount; one that is carried may restrict the new contract.
• Not checking MEC status of the old policy and the new one. A new life policy funded with a large lump sum can become a modified endowment contract and be taxed gains-first on loans and withdrawals.
• Resetting the clocks. A new life policy restarts the two-year the two-year contestability period and suicide exclusion, and an annuity or hybrid starts a new surrender schedule.
• Surrender charges on the old side. They may apply when the exchange happens, and the new product often starts its own.
• Losing old guarantees such as a low loan rate or a favorable guaranteed interest rate that the new contract will not match.
• Name and ownership mismatches that stall the transfer for weeks.
• Assuming the exchange makes the product better. It makes the tax deferral continue. Whether the new product is better is a separate question.

When to bring in a professional

Get a tax professional or fee-only financial planner to look at the exchange before the forms are signed if any of these is true: there is a policy loan, the policy may be a MEC, the policy is owned by a trust or business, the gain is large, you are close to a Medicare or Social Security income threshold, or the new product is complicated. Your state insurance department can answer questions about replacement rules and can take a complaint if the replacement was mishandled.

Key takeaways

• A 1035 exchange is a sequence: gather numbers, compare, apply, sign the exchange and replacement forms, transfer insurer to insurer, receive the contract, then handle the tax form.
• Leave the old policy in force and funded until the new contract is issued; cancelling it first is the costliest mistake.
• Money must move between insurers; a check made out to you, or a loan that vanishes, can create taxable boot.
• Expect new contestability, surrender and underwriting clocks on the new side, and a Form 1099-R with code 6 on the old side.
• The exchange defers tax and carries over your basis, but it does not by itself make the new contract a better one, so compare the guarantees and charges on paper first.