What’s a 1035 exchange? How it works & what’s allowable

Preparing for long-term financial health often requires pivoting strategies. A 1035 exchange is helpful in this regard because it lets you transfer funds from one annuity or life insurance policy to another without paying taxes upfront on your gains.

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Read on to discover what 1035 exchanges are, including how they work, the benefits, and potential limitations.

What’s a 1035 exchange?

A Section 1035 exchange lets you upgrade or replace one insurance or annuity contract for another — without paying taxes on the gains you accumulated. Instead of cashing out your old policy (which could trigger taxes), you transfer its value directly into a new policy or contract.This way, everything remains tax-deferred and you continue to build your savings without interruptions.

What’s allowable in a 1035 exchange?

The IRS allows Section 1035 exchanges for "like-kind" insurance products, meaning they serve a similar purpose or have comparable tax treatment. The general principle is that if an asset has built-up tax-deferred gains, exchanging it for another tax-deferred product ensures there’s no immediate tax consequences.

Here’s what you can exchange under Section 1035: 

• Life insurance for life insurance: Maybe your current life insurance policy doesn’t quite meet your needs anymore — perhaps it’s more expensive or lacks features like living benefits. With a 1035 exchange of life insurance, you can trade it for a better-fitting life insurance policy without losing your tax-deferred status.
• Life insurance for an endowment: Endowments can offer payouts sooner than life insurance policies, so that’s one exchange you could make to receive money faster.
• Life insurance for a non-qualified annuity: If, instead of a death benefit, you now want a steady income stream for retirement, you could turn a life insurance policy into a non-qualified annuity, which grows tax-deferred and pays out later in life.
• Endowment for endowment: If your endowment contract no longer fits your plans, you can exchange it for another one with better terms or benefits, giving you more control over your financial future.
• Endowment for a non-qualified annuity: Perhaps your endowment has served its purpose, and you’re ready for something different. By switching to a non-qualified annuity, you can focus on growing your money tax-deferred and receiving income later.
• Non-qualified annuity for non-qualified annuity: If your current annuity isn’t delivering the returns or features you want, you can do a 1035 annuity exchange with better rates or more flexible payout options.

What’s not allowable in a 1035 exchange

The reason some exchanges aren’t allowed is because they have fundamental differences in taxation, structure, or purpose. Essentially, the IRS doesn’t consider them “like-kind” exchanges. Here are some examples: 

• Transfers between qualified accounts: A 1035 exchange is designed for non-qualified accounts, meaning accounts funded with after-tax dollars. You can’t use it to move funds between accounts with a tax advantage like a 401(k) or traditional IRA. 
• Transfers from the account holder to the institution: The IRS doesn’t allow you to change the policy owner during a 1035 exchange. 
• Exchanges between different individuals: A 1035 exchange is personal — so you can’t swap a policy you own for one owned by someone else, even if it’s a family member. 
• Annuity to life insurance: You can’t exchange an annuity for life insurance because life insurance has a death benefit component, and annuities are primarily for income and accumulation, not for providing a lump-sum death benefit. This would allow the tax-deferred gains within the annuity to escape taxation via the life insurance death benefit, which is generally received tax-free. 
• Endowment to life insurance: Similarly, endowments usually mature at a specific date and pay out a lump sum, but life insurance remains in force indefinitely, so the transition isn’t “like-kind.” 
• Annuity to endowment: Because annuities focus on income over time, while endowments focus on offering lump sum payouts, which are typically tax-free, this potential for deferred gains to escape taxation takes this exchange off the table. 

Benefits of a 1035 exchange

If you’re considering upgrading your insurance policy or annuity, a 1035 exchange might help you reach your financial goals. Here are the top benefits of conducting one.

Tax advantage

The best part of this transfer is that you don’t have to pay taxes on gains at the time of transfer.Instead of losing part of your savings to taxes, you keep all your money working for you to grow tax-deferred, earning more compounded interest over time.

Flexibility and ease in trading financial products

Your goals, family, or financial priorities can change, and the opportunity a 1035 offers to pivot your strategies is priceless. You can simply transfer funds directly from one financial product to another, rather than cashing out and recommitting funds elsewhere.

Disadvantages of a 1035 exchange

A 1035 exchange can be a great way to adjust your financial plan, but it’s not without its challenges. Avoid costly mistakes by understanding the drawbacks.

Possible surrender charges and feature loss

Some policies or annuities charge surrender fees if you switch too soon, which can reduce the value of your exchange checks. Plus, you might lose unique benefits your current policy offers, like a high guaranteed interest rate or riders (extra features) you added. If you switch, you could lose these, so choose an option that's worth the trade-off.

Unexpected taxes and time limits

A 1035 exchange lets you transfer funds tax-deferred, but small transfer mistakes might lead to taxes — partner with a financial professional to make sure the exchange is conducted properly.
Some 1035 exchanges also have time limits and a processing window. Missing these deadlines could cause loss of benefits or ineligibility for the exchange.

What’s the difference between 1031 and 1035 exchanges?

A 1031 exchange is specific to real estate, while the 1035 exchange applies to insurance and investment products. Here’s more on their differences.

Asset type

A 1031 exchange applies to real estate, where you trade one property for another while deferring sales taxes. And a 1035 exchange deals with insurance policies and annuities, helping you upgrade or adjust these financial products without losing their tax-deferred benefits.

Timeframe

Timing is a big deal in a 1031 exchange — you have 45 days to identify a new property and 180 days to close the deal. That means you’re working on a strict schedule. With a 1035 exchange, you have much more flexibility. There are no hard deadlines, so you can take your time to evaluate your options and make the best decision.

Ownership

Ownership rules set these two exchanges apart. A 1031 exchange allows different ownership structures, like partnerships or LLCs, to complete the transaction. In a 1035 exchange, the same person (or entity) must remain the policyholder.

Overall process

A 1031 exchange is more complex. You’ll need a qualified intermediary to facilitate the deal, to follow strict property identification rules, and to coordinate multiple steps with precise documentation.

By contrast, a 1035 exchange is more straightforward. It’s a direct transfer between insurance companies or annuity providers.

How to know when a 1035 exchange is right for you

Here are a few scenarios where a 1035 exchange might be the right call: 

• More coverage: Your life insurance policy doesn’t provide enough protection for your current situation, so you want to upgrade.
• Adjusting annuity payments: Your lifestyle or retirement situation has changed, and you want to adjust your annuity payments.
• Change in personal health: Your health has impacted your ability to qualify for a new policy or is affecting your premiums.
• Outdated policy: Modern policies are offering better options and more flexible benefits.
• High fees: You want to stop paying high management and administrative costs.

This communication is for informational purposes only. It is not intended to provide, and should not be interpreted as, individualized investment, legal, or tax advice.

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