# Understanding 1035 Exchanges: Tax-Free Insurance and Annuity Transfers

![1035 Exchange](https://www.investopedia.com/thmb/5d3dNQqOUe5FVtxHV7CwmK5lTus=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/sec1035ex.asp-final-a8f06ab6a2f943f3b1524bb72bc4a728.jpg)

*— Investopedia / Eliana Rodgers*

## What Is a 1035 Exchange?

  
A 1035 exchange enables the tax-free transfer of certain financial products, such as annuity contracts and [life insurance](https://www.investopedia.com/terms/l/lifeinsurance.asp) policies, as outlined in the IRS code. This provision lets you replace your existing financial contract with another one of a similar type without incurring tax liabilities.

While full and partial exchanges are possible, specific rules governing these exchanges may differ by company. Generally, exchanges within the same company remain non-reportable for tax purposes, provided all criteria are met.

### Key Takeaways

*   A 1035 exchange allows tax-free transfers of life insurance policies, annuities, or endowments to similar products, provided that ownership remains unchanged.
*   While avoiding taxes, contract holders still need to consider fees and surrender charges, which may not be waived by insurers during a 1035 exchange.
*   Partial exchanges differ in tax treatment, as only a portion of the cost basis transfers to the new product.
*   Transfers between qualified accounts like IRAs or 401(k)s do not qualify as 1035 exchanges and cannot include annuity-to-life insurance swaps.
*   Reporting a 1035 exchange on tax returns is mandatory, though in-house exchanges might not require a 1099-R form.

## Understanding the Mechanics of a 1035 Exchange

A 1035 exchange allows individuals to transfer life insurance, annuities, and [endowments](https://www.investopedia.com/terms/e/endowment.asp) to a similar vehicle [tax-free](https://www.investopedia.com/terms/t/tax-free.asp). These transfers must be between similar products, such as life insurance for life insurance or a non-qualified [annuity](https://www.investopedia.com/terms/a/annuity.asp) for a non-qualified annuity. The [2006 Pension Protection Act (PPA)](https://www.investopedia.com/terms/p/pensionprotectionact2006.asp) modified IRC section 1035 to include exchanges from life insurance policies and non-qualified annuities into traditional and hybrid qualified [long-term care](https://www.investopedia.com/terms/l/ltcinsurance.asp) products.

Under a 1035 exchange, the contract or policy owner cannot take the funds and buy a new policy. The money must be transferred directly. The [annuitant](https://www.investopedia.com/terms/a/annuitant.asp) or policyholder must also remain the same.

For example, a 1035 exchange from an annuity owned by Joe Sample cannot be exchanged for an annuity owned by Jane Sample or a joint annuity owned by Joe and Jane Sample. The exchange must be reported on the individual's annual tax return using [Form 1099-R](https://www.investopedia.com/terms/f/form1099r.asp).  

> **Important**
>
> A life insurance policy can be exchanged for a non-qualified annuity, but a non-qualified annuity cannot be exchanged for a life insurance policy. 

## Evaluating the Costs and Benefits of a 1035 Exchange

The primary benefit of a [Section 1035](https://www.investopedia.com/articles/retirement/08/section-1035-exchange.asp) exchange is that it lets the contract or policy owner trade one product for another without tax consequences. Outdated and [underperforming](https://www.investopedia.com/terms/u/underperform.asp) products can be switched to newer products with more attractive features, such as better investment options and less restrictive provisions.

Even with tax benefits, 1035 exchanges don't remove obligations from the original contract. For example, insurance companies typically don't waive surrender charges for 1035 exchanges. However, fees may be waived if the owner exchanges one product for another within the same company.

Owners should compare each policy's features and perform a [cost-benefit analysis](https://www.investopedia.com/terms/c/cost-benefitanalysis.asp) before exchange. The new policy should match an individual's investment goals. Owners should consider the administrative fees and transaction charges, such as withdrawal or [surrender charges](https://www.investopedia.com/terms/s/surrendercharge.asp). Evaluate the [financial institution](https://www.investopedia.com/ask/answers/061615/what-are-major-categories-financial-institutions-and-what-are-their-primary-roles.asp) on its management of assets, liabilities, and any shareholder obligations.

> **Fast Fact**
>
> The tax treatment differs for partial exchanges in that a portion of the cost basis is allocated to the new product rather than all of it.

## Example: Navigating a 1035 Exchange

Joe Sample invested $100,000 (the cost basis) in a non-qualified annuity. Joe took no loans or withdrawals, so the value remains unaffected. Because of poor investment performance, the value of the [annuity](https://www.investopedia.com/terms/a/annuity.asp) dropped to $75,000.

Dissatisfied, Joe transfers his funds into another annuity with another company. In this scenario, the original contract's cost basis of $100,000 becomes the new contract's basis, although just $75,000 was transferred.  

## What Is Not Allowed in a 1035 Exchange?

Transfers between qualified accounts, such as IRAs and 401(k)s, are not characterized as 1035 exchanges. Under a 1035 exchange, the IRS disallows the transfer of funds from the account holder to the institution, exchanges between like-kind accounts where the annuitant or owner on the existing account is not the same on the new account, annuity to life insurance, endowment to life insurance, and annuity to endowment.

## Do Individuals Have to Report a 1035 Exchange on a Tax Return?

A 1035 exchange must be reported on a tax return. If the funds are transferred from institution to institution, the transferring company will issue a 1099-R form, recording the amount transferred and a distribution code to denote a 1035 exchange. Although the transaction is reportable, it is not taxable. If the exchange occurs in-house, the financial institution may not issue a 1099-R.

## What Is the Difference Between a Replacement and a 1035 Exchange?

A 1035 exchange is a replacement, however, not every replacement qualifies as a 1035 exchange. When an annuity or life insurance policy is exchanged into another annuity, it is a replacement and 1035 exchange. Swapping an annuity for a life insurance policy counts as a replacement but not a 1035 exchange. Such transactions are taxable, with gains and losses recognized.

## The Bottom Line

Section 1035 of the Internal Revenue Code allows for the non-taxable exchange of certain insurance products. Permitted exchanges are life insurance to an annuity, annuity to annuity, endowment to endowment, and life insurance to life insurance. The cost basis of the old policy or contract becomes the basis of the new one, despite losses that have eroded the balance. Policyholders should exercise caution when exchanging one product for another, paying careful attention to forgone benefits, charges, fees, and alignment with goals and objectives.  

> **Article Sources**
>
> 1.  U.S. Congress, The Joint Committee on Taxation. "[Technical Explanation of H.R. 4, the 'Pension Protection Act of 2006,' as Passed by the House on July 28, 2006, and as Considered by the Senate on August 3, 2006](https://www.jct.gov/publications/2006/jcx-38-06/)," Pages 194-195. Download PDF.
>     
> 2.  Internal Revenue Service. "[26 CFR: 1.1035-1: Certain Exchanges of Insurance Policies: Rev. Rul. 2007-24](https://www.irs.gov/pub/irs-drop/rr-07-24.pdf)."
>     
> 3.  Code of Federal Regulations. "[26 CFR 1.1035-1 - Certain Exchanges of Insurance Policies](https://www.govinfo.gov/content/pkg/CFR-2012-title26-vol11/pdf/CFR-2012-title26-vol11-sec1-1035-1.pdf)," Page 143.
>     
> 4.  Internal Revenue Service. "[Instructions for Forms 1099-R and 5498: Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc.](https://www.irs.gov/pub/irs-pdf/i1099r.pdf)," Page 2.
>     
> 5.  Internal Revenue Service. "[26 CFR 1.1035-1: Certain Exchanges of Insurance Policies; Notice 2003-51](https://www.irs.gov/pub/irs-drop/n-03-51.pdf)," Page 2-3.
>     
> 6.  Code of Federal Regulations. "[26 CFR 1.1035-1 - Certain Exchanges of Insurance Policies](https://www.govinfo.gov/content/pkg/CFR-2012-title26-vol11/pdf/CFR-2012-title26-vol11-sec1-1035-1.pdf)."
>     
> 7.  Internal Revenue Service. "[Instructions for Forms 1099-R and 5498: Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc.](https://www.irs.gov/pub/irs-pdf/i1099r.pdf)," Pages 2, 15.