# What Is a 1035 Exchange? Published: 2026-01-08 Author: Warren Team URL: https://www.heywarren.com/blog/10-35-exchange --- Most people pay tens of thousands of dollars in unnecessary taxes simply because they didn't know about a little-known [IRS](https://www.irs.gov/) provision that lets you swap one insurance or annuity contract for a better one, completely tax-free. The problem is that many policyholders feel trapped. They're holding an underperforming annuity or an outdated life insurance policy with a mountain of built-in gains, and they assume cashing out means handing a chunk to the IRS. That assumption costs American savers an estimated $2 billion in avoidable taxes every year, according to industry estimates. A 10 35 exchange, named after Section 1035 of the Internal Revenue Code, changes that equation entirely. In this guide, you'll learn exactly what a 1035 exchange is, which contracts qualify, how the transfer process works step by step, and the critical mistakes that can inadvertently trigger a taxable event. By the end, you'll know whether a 1035 exchange belongs in your financial strategy and how to execute one cleanly. The IRS has allowed these exchanges since the 1950s, and they remain one of the most underused tools in personal financial planning. --- ## What Is a 1035 Exchange? A 1035 exchange is a tax-free transfer of funds from one life insurance policy, annuity contract, or long-term care insurance policy into a similar contract, permitted under Section 1035 of the Internal Revenue Code. The exchange preserves your original cost basis and defers any accumulated gains, meaning you owe no income tax at the time of the swap. Think of it as a like-kind exchange for insurance products, similar in spirit to the real estate Section 1031 exchange, but applied to policies rather than property. The IRS's rationale is straightforward: you haven't actually received the money, so there's nothing to tax yet. ### Why the IRS Created This Provision Congress enacted Section 1035 to prevent policyholders from being locked into inferior products. Before this rule, switching from a poorly designed whole life policy to a better annuity meant recognizing all accumulated gains as ordinary income in the year of the switch, a punishing tax bill that made shopping for better products economically irrational. The 1035 exchange solved this. Gains continue to compound tax-deferred in the new contract, and the IRS collects its revenue only when the policyholder eventually takes distributions. Both parties benefit from the deferral. ### The Cost Basis Rule When you execute a 1035 exchange, your original cost basis, the total premiums you paid into the old contract, transfers to the new one. If you paid $80,000 in premiums into an annuity now worth $150,000, the new annuity inherits the $80,000 basis. The $70,000 in gains are still deferred, not forgiven. You will owe ordinary income tax on those gains when you take withdrawals, just as you would have in the original contract. --- ## How a 10 35 Exchange Works Step by Step Executing a 1035 exchange is a direct transfer between insurance companies, you never personally receive a check. The IRS requires a trustee-to-trustee transfer to preserve the tax-free status of the swap. ![In a 1035 exchange, funds move directly carrier-to-carrier, the policyholder never receives the money, preserving tax-free status.](data:image/svg+xml,%3Csvg%20xmlns%3D%22http%3A%2F%2Fwww.w3.org%2F2000%2Fsvg%22%20viewBox%3D%220%200%20660%20125%22%20width%3D%22660%22%20height%3D%22125%22%20role%3D%22img%22%3E%3Ctitle%3EFlow%20diagram%3C%2Ftitle%3E%3Crect%20width%3D%22100%25%22%20height%3D%22100%25%22%20fill%3D%22%23f8fafc%22%2F%3E%3Crect%20x%3D%2230%22%20y%3D%2225%22%20width%3D%22170%22%20height%3D%2275%22%20rx%3D%2210%22%20fill%3D%22white%22%20stroke%3D%22%232563eb%22%20stroke-width%3D%222%22%2F%3E%3Ctext%20x%3D%22115%22%20y%3D%2258.5%22%20text-anchor%3D%22middle%22%20font-family%3D%22system-ui%2C-apple-system%2Csans-serif%22%20font-size%3D%2214%22%20font-weight%3D%22600%22%20fill%3D%22%230f172a%22%3EOld%20Contract%3C%2Ftext%3E%3Ctext%20x%3D%22115%22%20y%3D%2278.5%22%20text-anchor%3D%22middle%22%20font-family%3D%22system-ui%2C-apple-system%2Csans-serif%22%20font-size%3D%2211%22%20fill%3D%22%2364748b%22%3EExisting%20carrier%3C%2Ftext%3E%3Cline%20x1%3D%22205%22%20y1%3D%2262.5%22%20x2%3D%22237%22%20y2%3D%2262.5%22%20stroke%3D%22%2364748b%22%20stroke-width%3D%222%22%2F%3E%3Cpolygon%20points%3D%22244%2C62.5%20235%2C57.5%20235%2C67.5%22%20fill%3D%22%2364748b%22%2F%3E%3Crect%20x%3D%22245%22%20y%3D%2225%22%20width%3D%22170%22%20height%3D%2275%22%20rx%3D%2210%22%20fill%3D%22white%22%20stroke%3D%22%232563eb%22%20stroke-width%3D%222%22%2F%3E%3Ctext%20x%3D%22330%22%20y%3D%2258.5%22%20text-anchor%3D%22middle%22%20font-family%3D%22system-ui%2C-apple-system%2Csans-serif%22%20font-size%3D%2214%22%20font-weight%3D%22600%22%20fill%3D%22%230f172a%22%3EDirect%20Transfer%3C%2Ftext%3E%3Ctext%20x%3D%22330%22%20y%3D%2278.5%22%20text-anchor%3D%22middle%22%20font-family%3D%22system-ui%2C-apple-system%2Csans-serif%22%20font-size%3D%2211%22%20fill%3D%22%2364748b%22%3ECarrier-to-carrier%3C%2Ftext%3E%3Cline%20x1%3D%22420%22%20y1%3D%2262.5%22%20x2%3D%22452%22%20y2%3D%2262.5%22%20stroke%3D%22%2364748b%22%20stroke-width%3D%222%22%2F%3E%3Cpolygon%20points%3D%22459%2C62.5%20450%2C57.5%20450%2C67.5%22%20fill%3D%22%2364748b%22%2F%3E%3Crect%20x%3D%22460%22%20y%3D%2225%22%20width%3D%22170%22%20height%3D%2275%22%20rx%3D%2210%22%20fill%3D%22white%22%20stroke%3D%22%232563eb%22%20stroke-width%3D%222%22%2F%3E%3Ctext%20x%3D%22545%22%20y%3D%2258.5%22%20text-anchor%3D%22middle%22%20font-family%3D%22system-ui%2C-apple-system%2Csans-serif%22%20font-size%3D%2214%22%20font-weight%3D%22600%22%20fill%3D%22%230f172a%22%3ENew%20Contract%3C%2Ftext%3E%3Ctext%20x%3D%22545%22%20y%3D%2278.5%22%20text-anchor%3D%22middle%22%20font-family%3D%22system-ui%2C-apple-system%2Csans-serif%22%20font-size%3D%2211%22%20fill%3D%22%2364748b%22%3EReceiving%20carrier%3C%2Ftext%3E%3C%2Fsvg%3E) *In a 1035 exchange, funds move directly carrier-to-carrier, the policyholder never receives the money, preserving tax-free status.* Here is the process from start to finish: 1. **Identify the new contract.** Work with a licensed insurance professional or independent advisor to select a replacement policy or annuity. Compare surrender charges, expense ratios, death benefits, and rider options. 2. **Submit a 1035 exchange request form.** The receiving (new) insurance company provides this paperwork. Do not submit a withdrawal or surrender request to your current carrier, that would trigger a taxable distribution. 3. **Provide policy details.** The new carrier needs your existing policy number, the insurance company's name, and the transfer amount (full or partial). 4. **The new carrier contacts the old carrier directly.** The receiving company initiates the transfer on your behalf. You are not in the chain of custody for the funds. 5. **Surrender charges may apply.** If your current contract has a surrender charge period, typically seven to ten years, those fees still apply even in a 1035 exchange. Factor this cost into your break-even analysis. 6. **Confirm the transfer.** Once complete, verify with both companies that the exchange was recorded as a 1035 transfer and not a taxable [liquidation](/blog/define-liquidation). Request written confirmation. The entire process typically takes two to six weeks, depending on the carriers involved. --- ## Which Contracts Qualify for a Section 1035 Exchange Not every insurance product can be swapped tax-free. The IRS defines a strict hierarchy of permissible exchanges, and moving in the wrong direction, or between the wrong product types, eliminates the tax benefit. ![The IRS permits exchanges only in specific directions, annuities cannot be exchanged up into life insurance.](data:image/svg+xml,%3Csvg%20xmlns%3D%22http%3A%2F%2Fwww.w3.org%2F2000%2Fsvg%22%20viewBox%3D%220%200%20760%20211%22%20width%3D%22760%22%20height%3D%22211%22%20role%3D%22img%22%3E%3Ctitle%3EHierarchy%3C%2Ftitle%3E%3Crect%20width%3D%22100%25%22%20height%3D%22100%25%22%20fill%3D%22%23f8fafc%22%2F%3E%3Crect%20x%3D%22300%22%20y%3D%2220%22%20width%3D%22160%22%20height%3D%2258%22%20rx%3D%228%22%20fill%3D%22%232563eb%22%2F%3E%3Ctext%20x%3D%22380%22%20y%3D%2254%22%20text-anchor%3D%22middle%22%20font-family%3D%22system-ui%2C-apple-system%2Csans-serif%22%20font-size%3D%2214%22%20font-weight%3D%22700%22%20fill%3D%22white%22%3E1035%20Exchange%3C%2Ftext%3E%3Cpath%20d%3D%22M%20380%2078%20L%20380%20105.5%20L%20110%20105.5%20L%20110%20133%22%20stroke%3D%22%23cbd5e1%22%20stroke-width%3D%222%22%20fill%3D%22none%22%2F%3E%3Crect%20x%3D%2230%22%20y%3D%22133%22%20width%3D%22160%22%20height%3D%2258%22%20rx%3D%228%22%20fill%3D%22white%22%20stroke%3D%22%230891b2%22%20stroke-width%3D%222%22%2F%3E%3Ctext%20x%3D%22110%22%20y%3D%22158%22%20text-anchor%3D%22middle%22%20font-family%3D%22system-ui%2C-apple-system%2Csans-serif%22%20font-size%3D%2213%22%20font-weight%3D%22600%22%20fill%3D%22%230f172a%22%3ELife%20%E2%86%92%20Life%3C%2Ftext%3E%3Ctext%20x%3D%22110%22%20y%3D%22176%22%20text-anchor%3D%22middle%22%20font-family%3D%22system-ui%2C-apple-system%2Csans-serif%22%20font-size%3D%2210%22%20fill%3D%22%2364748b%22%3ESame%20insured%20required%3C%2Ftext%3E%3Cpath%20d%3D%22M%20380%2078%20L%20380%20105.5%20L%20290%20105.5%20L%20290%20133%22%20stroke%3D%22%23cbd5e1%22%20stroke-width%3D%222%22%20fill%3D%22none%22%2F%3E%3Crect%20x%3D%22210%22%20y%3D%22133%22%20width%3D%22160%22%20height%3D%2258%22%20rx%3D%228%22%20fill%3D%22white%22%20stroke%3D%22%230891b2%22%20stroke-width%3D%222%22%2F%3E%3Ctext%20x%3D%22290%22%20y%3D%22158%22%20text-anchor%3D%22middle%22%20font-family%3D%22system-ui%2C-apple-system%2Csans-serif%22%20font-size%3D%2213%22%20font-weight%3D%22600%22%20fill%3D%22%230f172a%22%3ELife%20%E2%86%92%20Annuity%3C%2Ftext%3E%3Ctext%20x%3D%22290%22%20y%3D%22176%22%20text-anchor%3D%22middle%22%20font-family%3D%22system-ui%2C-apple-system%2Csans-serif%22%20font-size%3D%2210%22%20fill%3D%22%2364748b%22%3EOne-way%20only%3C%2Ftext%3E%3Cpath%20d%3D%22M%20380%2078%20L%20380%20105.5%20L%20470%20105.5%20L%20470%20133%22%20stroke%3D%22%23cbd5e1%22%20stroke-width%3D%222%22%20fill%3D%22none%22%2F%3E%3Crect%20x%3D%22390%22%20y%3D%22133%22%20width%3D%22160%22%20height%3D%2258%22%20rx%3D%228%22%20fill%3D%22white%22%20stroke%3D%22%230891b2%22%20stroke-width%3D%222%22%2F%3E%3Ctext%20x%3D%22470%22%20y%3D%22158%22%20text-anchor%3D%22middle%22%20font-family%3D%22system-ui%2C-apple-system%2Csans-serif%22%20font-size%3D%2213%22%20font-weight%3D%22600%22%20fill%3D%22%230f172a%22%3EAnnuity%20%E2%86%92%20Annuity%3C%2Ftext%3E%3Ctext%20x%3D%22470%22%20y%3D%22176%22%20text-anchor%3D%22middle%22%20font-family%3D%22system-ui%2C-apple-system%2Csans-serif%22%20font-size%3D%2210%22%20fill%3D%22%2364748b%22%3EMost%20common%3C%2Ftext%3E%3Cpath%20d%3D%22M%20380%2078%20L%20380%20105.5%20L%20650%20105.5%20L%20650%20133%22%20stroke%3D%22%23cbd5e1%22%20stroke-width%3D%222%22%20fill%3D%22none%22%2F%3E%3Crect%20x%3D%22570%22%20y%3D%22133%22%20width%3D%22160%22%20height%3D%2258%22%20rx%3D%228%22%20fill%3D%22white%22%20stroke%3D%22%230891b2%22%20stroke-width%3D%222%22%2F%3E%3Ctext%20x%3D%22650%22%20y%3D%22158%22%20text-anchor%3D%22middle%22%20font-family%3D%22system-ui%2C-apple-system%2Csans-serif%22%20font-size%3D%2213%22%20font-weight%3D%22600%22%20fill%3D%22%230f172a%22%3ELife%2FAnnuity%20%E2%86%92%20LTC%3C%2Ftext%3E%3Ctext%20x%3D%22650%22%20y%3D%22176%22%20text-anchor%3D%22middle%22%20font-family%3D%22system-ui%2C-apple-system%2Csans-serif%22%20font-size%3D%2210%22%20fill%3D%22%2364748b%22%3ESince%202006%3C%2Ftext%3E%3C%2Fsvg%3E) *The IRS permits exchanges only in specific directions, annuities cannot be exchanged up into life insurance.* ### Life Insurance to Life Insurance or Annuity You can exchange a life insurance policy for another life insurance policy on the same insured. This makes sense when your current policy has high internal costs, a weak death benefit, or outdated [underwriting](/blog/what-is-underwriting). You can also exchange a life insurance policy for an annuity contract. This is a one-way street: the IRS permits the downgrade from an insurance product to a savings vehicle, but not the reverse. Moving an annuity into a life insurance policy does not qualify for 1035 treatment. ### Annuity to Annuity An annuity contract can be exchanged for another annuity contract. This is the most common 1035 exchange in practice. A policyholder holding a variable annuity with a 1.4% annual expense ratio might exchange it for a low-cost fixed indexed annuity charging 0.25%, locking in a dramatically lower fee structure without a tax hit. The insured does not have to be the same person in annuity-to-annuity exchanges, but the owner must remain identical. If two people jointly own an annuity, both must remain co-owners of the replacement contract. ### Long-Term Care and Endowment Exchanges Since the Pension Protection Act of 2006, the IRS also permits: - **Life insurance to long-term care insurance**: A powerful planning tool for older policyholders who no longer need the death benefit but want coverage for nursing home or in-home care costs. - **Annuity to long-term care insurance**: Similarly, a [deferred annuity](/blog/deferred-annuities) can be exchanged for a qualifying long-term care contract. - **Endowment contracts**: An endowment policy can be exchanged for another endowment, a life insurance policy, or an annuity, in that order of permissible direction. ### What Does Not Qualify - Exchanging a modified endowment contract (MEC) does not convert it to a non-MEC. - Variable life insurance surrendered and re-purchased outside a direct transfer loses 1035 status. - Group insurance contracts and term life policies with no cash value generally cannot participate in a 1035 exchange because there are no accumulated gains to transfer. --- ## When a 10 35 Exchange Makes Financial Sense The 1035 exchange is a tool, not a universal solution. Using it wisely requires comparing the cost of the exchange against the long-term benefit of the new contract. ![A $200,000 annuity at 3% annual fees costs roughly $88,000 more than one charging 0.75% over 20 years.](data:image/svg+xml,%3Csvg%20xmlns%3D%22http%3A%2F%2Fwww.w3.org%2F2000%2Fsvg%22%20viewBox%3D%220%200%20800%20210%22%20width%3D%22800%22%20height%3D%22210%22%20role%3D%22img%22%3E%3Ctitle%3EComparison%3C%2Ftitle%3E%3Crect%20width%3D%22100%25%22%20height%3D%22100%25%22%20fill%3D%22%23f8fafc%22%2F%3E%3Ctext%20x%3D%22230%22%20y%3D%2257.5%22%20text-anchor%3D%22end%22%20font-family%3D%22system-ui%2C-apple-system%2Csans-serif%22%20font-size%3D%2214%22%20font-weight%3D%22600%22%20fill%3D%22%230f172a%22%3EHigh-fee%20%283%25%29%3C%2Ftext%3E%3Crect%20x%3D%22240%22%20y%3D%2225%22%20width%3D%22450%22%20height%3D%2255%22%20rx%3D%226%22%20fill%3D%22%232563eb%22%2F%3E%3Ctext%20x%3D%22702%22%20y%3D%2257.5%22%20font-family%3D%22system-ui%2C-apple-system%2Csans-serif%22%20font-size%3D%2214%22%20font-weight%3D%22700%22%20fill%3D%22%232563eb%22%3E%2488K%3C%2Ftext%3E%3Ctext%20x%3D%22230%22%20y%3D%22152.5%22%20text-anchor%3D%22end%22%20font-family%3D%22system-ui%2C-apple-system%2Csans-serif%22%20font-size%3D%2214%22%20font-weight%3D%22600%22%20fill%3D%22%230f172a%22%3ELow-fee%20%280.75%25%29%3C%2Ftext%3E%3Crect%20x%3D%22240%22%20y%3D%22120%22%20width%3D%226%22%20height%3D%2255%22%20rx%3D%226%22%20fill%3D%22%237c3aed%22%2F%3E%3Ctext%20x%3D%22258%22%20y%3D%22152.5%22%20font-family%3D%22system-ui%2C-apple-system%2Csans-serif%22%20font-size%3D%2214%22%20font-weight%3D%22700%22%20fill%3D%22%237c3aed%22%3E%240%3C%2Ftext%3E%3C%2Fsvg%3E) *A $200,000 annuity at 3% annual fees costs roughly $88,000 more than one charging 0.75% over 20 years.* ### You Are Holding an Underperforming or Expensive Annuity Variable annuities sold in the 1990s and early 2000s frequently carried mortality and expense charges of 1.25% to 1.75% per year, plus underlying fund fees of another 0.75% to 1.50%. Total annual costs of 2% to 3% compound dramatically over decades, a $200,000 annuity paying 3% annual costs loses roughly $88,000 more over 20 years than one charging 0.75%. If your current annuity has no remaining surrender charge period, a 1035 exchange into a lower-cost product can save tens of thousands of dollars in fees over your retirement timeline. ### Your Life Insurance Policy Has Outlived Its Purpose A whole life or universal life policy purchased in your 30s for income replacement may be unnecessary once your mortgage is paid, your children are financially independent, and your retirement accounts are fully funded. The accumulated cash value in that policy can be exchanged into an annuity to generate guaranteed retirement income, without recognizing a dollar of gain. ### You Need Long-Term Care Coverage but Have an Old Policy A life insurance policy with $120,000 in cash value and a $300,000 death benefit can be exchanged for a hybrid long-term care policy that covers nursing home costs up to $400,000 over four years. The policyholder avoids the tax on the $120,000 in built-in gains and simultaneously solves a long-term care planning gap. This is one of the most tax-efficient restructuring strategies available to pre-retirees aged 55 to 70. --- ## Common Mistakes That Invalidate a 1035 Exchange Even a small procedural error can transform a tax-free exchange into a fully taxable event. These are the mistakes financial advisors see most often. ### Taking a Check Personally If the surrender proceeds from your old contract are ever paid to you, even briefly, the IRS treats the [transaction](/blog/what-is-a-transactions) as a taxable distribution followed by a new purchase. It does not matter if you immediately reinvest the money. The constructive receipt rule applies the moment funds are in your control. Always use a direct carrier-to-carrier transfer. ### Mismatching Owners or Insureds The owner of the old contract must be the owner of the new contract. If the insured changes, say, moving from a policy on a parent's life to one on a spouse, the 1035 treatment is disqualified. Some carriers allow the insured to change for underwriting purposes after the exchange is complete, but the initial transfer must mirror the ownership structure exactly. ### Ignoring Surrender Charges in the Break-Even Analysis A 1035 exchange is tax-free, but it is not fee-free. If your current annuity carries a 7% surrender charge on a $300,000 contract, you're forfeiting $21,000 on exit. Calculate how many years it takes for the fee savings in the new contract to exceed $21,000. If that break-even point is beyond your retirement horizon, the exchange may not make economic sense even though the tax treatment is favorable. ### Partial Exchanges and the Two-Year Rule Since 2011, the IRS has scrutinized partial [1035 exchanges](/blog/1035-exchanges), where only a portion of one annuity is transferred to a new contract. If you take a distribution from either the old or new contract within two years of a partial exchange, the IRS may recharacterize the entire partial transfer as taxable. Avoid any withdrawals from either contract for 24 months after a partial 1035 exchange. --- ## Tax Reporting for a 1035 Exchange Even though a properly executed 1035 exchange generates no tax liability, the IRS still requires reporting. Insurance companies issue a **Form 1099-R** for the surrendered contract, using distribution code **6** in Box 7, which signals a tax-free 1035 exchange to the IRS. On your federal tax return, report the exchange on **Form 8606** if there are any after-tax contributions involved, and ensure the 1099-R is entered with the correct code. Tax software generally handles this automatically, but verify the entry before filing. If the exchange involves a modified endowment contract, additional rules apply under IRC Section 72(e). Consult a tax advisor or CPA with insurance policy experience before filing. --- ## Authoritative Sources For deeper background and primary-source data on this topic, the following authoritative sources are useful starting points: - [SEC](https://www.sec.gov/) - [Federal Reserve](https://www.federalreserve.gov/) - [Consumer Financial Protection Bureau](https://www.consumerfinance.gov/) - [U.S. Department of the Treasury](https://home.treasury.gov/) - [Bureau of Labor Statistics](https://www.bls.gov/) ## Conclusion The 10 35 exchange is one of the most powerful and most overlooked tools in personal financial planning. Used correctly, it allows you to upgrade an underperforming or expensive insurance or annuity contract without triggering a tax bill on years of accumulated gains. Here are the key takeaways: - A **1035 exchange** transfers funds directly between insurance companies, you never touch the money, and no taxable distribution occurs. - The IRS permits exchanges from life insurance to life insurance, life insurance to annuity, and annuity to annuity, but not in reverse for the annuity-to-life direction. - Your **original cost basis** carries over to the new contract; gains remain deferred until withdrawal. - **Surrender charges still apply**, so always run a break-even analysis before proceeding. - Never receive a personal check, always use a **trustee-to-trustee direct transfer**. - Partial exchanges trigger a **two-year lookback rule**, avoid any withdrawals from either contract for 24 months. The 10 35 exchange is not right for every situation, but for policyholders holding expensive, outdated contracts with significant built-in gains, it is often the single most impactful tax-planning move available. As you review your own policies, run the numbers on fees, surrender charges, and break-even timelines, the savings can be substantial. Ready to put this knowledge to work? Try Warren, your AI financial advisor, get personalized, conflict-free guidance at heywarren.com