1035 Exchange Rules

The U.S. Tax Code, in sections 1035-1045, provides that property can be exchanged for property of equal value without incurring a tax liability. Section 1035 applies to insurance products, including life insurance policies and annuities.

Financial Plan
1035 Exchanges allow updating insurance policies and annuities without taxes.
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Exchanging Life Insurance for Life Insurance

Under 1035 Exchange rules, a life insurance policy can be exchanged for another life insurance policy. All proceeds from the liquidation of the first policy can transfer to the second without triggering a tax event. This is a one-for-one transaction: the transfer of two individual policies to a single, multi-insured policy is not permitted, and you may not exchange a single life policy for a survivorship policy.

Endowment Contracts

Congress has imposed a cap on how much you can pay into a life insurance policy and still qualify for tax benefits. If you exceed that amount, your insurance policy is classified as a modified endowment contract (MEC).

Single premium policies--which you fund with a lump sum cash payment at purchase--qualify as MECs. Policies for which you pay the premiums over time can avoid the MEC classification provided the polices pass the "seven-pay test." During the first seven years of the policy, the total you pay into it must not exceed amount that would spend to pay off the policy in seven years.

If you have a life insurance policy in the form of a modified endowment contract (MEC), whatever you exchange it for--even if the policy would not qualify as an MEC as a standalone--becomes an MEC under the principle of "once a MEC, always a MEC." However, if you have a policy that's not a MEC, but you exchange it for a policy that fails the seven-pay test, your new policy becomes a MEC.

Annuties for Annuities

Annuities (or special insurance investments offered as long-term savings or retirement options by insurance companies) can be 1035-transfered for other annuities. As with life insurance policies, the 1035 Exchange allows the exchange of annuities so policy holders can find better rates for their investments or to accommodate changes in their financial situation.

Life Insurance to Annuities

In case a policy holder no longer requires death benefits, a life insurance policy can 1035-transfer to an annuity. However, transferring annuities to life insurance policies is not permitted. Switching an annuity for a life insurance policy may result in tax being levied against any gains from the annuity.