Tax-Free 1035 Exchanges

Question 1

What does a Section 1035 Exchange allow you to do?

Answer 1

Through Section 1035 of the federal Tax Code, life insurance policies and annuity contracts can be exchanged without any gain being recognized or taxed.

Such a transaction is called a 1035 exchange. For example: A life insurance policy may be exchanged tax free for another life insurance policy, of any type. A deferred annuity contract may be exchanged tax free for another annuity, of any type. Also, a life insurance policy may be exchanged tax free for an annuity (but not vice versa).

Question 2

Allowable 1035 Exchanges

What is the only exchange that is NOT allowed? Why not?

Answer 2

Under Section 1035, the following tax-free exchanges are allowed:

• an annuity for an annuity
• a life insurance policy for an annuity
• a life insurance policy for another life insurance policy
• a life insurance policy for an endowment policy
• an endowment policy for another endowment policy (as long as the maturity date of the new policy is no later than the maturity date of the original policy)

Notice that an annuity cannot be exchanged tax free for a life insurance policy. That is because annuities are eventually taxed (on their gain) while life insurance policy death benefits are exempt from taxation.

Question 3

Key Points

Answer 3

• A life insurance policy may be exchanged tax free for another life insurance policy, of any type.
• A deferred annuity contract may be exchanged tax free for another annuity, of any type.
• A life insurance policy may be exchanged tax free for an annuity.
• an annuity cannot be exchanged tax free for a life insurance policy.