What Is a 1035 Exchange? Rules & Tax Benefits

By Brent Meyer — SafeMoney.com Founder & Editor Reviewed by Licensed Financial Professionals  |  SafeMoney.com — Trusted Since 2011  |  Updated Regularly Quick Answer: A 1035 exchange lets you transfer life insurance or annuity contracts without paying taxes. Learn the IRS rules, qualifying products, and step-by-step process. Do you have a current annuity or insurance policy that doesn’t fit your needs well? If you are on the lookout for a new policy, a 1035 exchange may be a worthwhile option. A 1035 exchange is a section of the U.S. tax code that lets policyholders replace an existing annuity or insurance policy with a new policy – and with no tax consequences. This tax-free exchange may be used for life insurance policies, modified endowment contracts (MECs for short), and non-qualified annuities toward a new policy. With new waves of innovation available – such as living benefits for terminal illnesses or long-term care situations – you might wish to explore new options. The good news is you don’t have to keep your current policy forever. Let’s take a closer look at how a 1035 exchange may and may not benefit a policyholder looking for new annuity or insurance choices. How a 1035 Exchange Works A 1035 exchange refers to Section 1035 of the Internal Revenue Code. Those code provisions enable you to transfer funds from a non-qualified annuity , a MEC, or a life insurance policy into a qualifying new policy without having to pay taxes. Section 1035 includes a “like-kind” rule for a tax-free exchange. Your current policy can be exchanged only for a limited number of kinds of other policies. This is one of many reasons why it’s important to pay careful attention to what you do with your 1035 exchange request. That way it happens on a tax-neutral basis, and no slip-ups occur where you will end up with a tax bill. Speaking of mistakes, here’s a more common one. For no taxes to be due, the actual transfer of policy funds must be from current insurance company to new insurance company. In other words, the carrier with your current policy must transfer the funds directly to the carrier issuing the new policy. An exchange with you, as the policyholder, directly handling the to-be-transferred funds at some point could wind up with you paying taxes on them. What Like-Kind Exchanges Qualify for a 1035 Exchange? Under IRS tax rules, the following exchanges in the flowmap below are permitted.  In other words, these exchanges may qualify as