By Marc Gilman
Questions? Call (800) 927-9326 or email
Key Takeaways
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A 1035 exchange lets you move the cash value of a life insurance policy or annuity into a new contract without paying tax on the gain at the time of the switch. The tax isn’t eliminated — your original cost basis carries over, so it’s deferred, not erased.
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Not every direction of exchange qualifies. Life-to-life, life-to-annuity, and annuity-to-annuity exchanges can all be done tax-free. An annuity-to-life exchange cannot.
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The money has to move directly between carriers. You never take possession of the cash — the old carrier sends it straight to the new one, which is what preserves the tax-free treatment.
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A 1035 exchange isn’t free. New surrender charges may apply, and you’ll face new up-front fees, a new commission, and — for a life insurance exchange specifically — new underwriting and a new two-year contestability period.
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If it’s a life-to-annuity exchange, there’s typically no new underwriting — annuities generally don’t require health questions, which matters most for older policyholders or anyone whose health has changed since the original policy was issued.
What a 1035 Exchange Actually Is
Named for the section of the tax code that authorizes it, a 1035 exchange is a way to transfer the cash value from a permanent life insurance policy or an annuity into a new contract without treating the transfer as a taxable event. Normally, cashing out a policy with cash-value gains means paying income tax on the amount above what you paid in premiums (your basis). A 1035 exchange sidesteps that tax bill at the time of the switch by moving the value directly into a new contract instead of into your hands first.
The deferral isn’t a tax elimination — your original cost basis simply carries over to the new contract, so the eventual tax bill on any gain still exists, just pushed further down the road. Term life insurance doesn’t have cash value, so 1035 exchanges don’t apply to it. And if you die with a policy still in force, your beneficiaries receive the death benefit tax-free regardless of whether a 1035 exchange was ever involved.
Which Exchanges Actually Qualify
Not every direction of exchange gets the tax-free treatment:
That last row trips people up. Once money is in an annuity, it can move tax-free to another annuity, but it can’t move tax-free into a life insurance policy.
How the Money Actually Moves
The mechanics matter for the tax treatment to hold: the cash value has to transfer directly from the old carrier to the new one. You never take possession of the money yourself. It’s typically applied as a single lump-sum premium into the new policy, even when that new policy is otherwise structured around ongoing premium payments.
Doing a 1035 exchange doesn’t change or skip the application process for the new contract. If you’re exchanging into a new life insurance policy, you still go through full underwriting — the new carrier assesses your health and other risk factors just as it would for a new policy bought with new money, which matters most for older applicants or anyone whose health has changed since the original policy was issued. Exchanging into an annuity is different: annuities generally don’t require health underwriting, so there are typically no health questions involved in a life-to-annuity exchange.
Common Reasons People Do This
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Shifting from a death benefit to retirement income. Someone who bought cash-value life insurance decades ago may find, heading into retirement, that they need income more than they need the death benefit — a life-to-annuity exchange redirects that value accordingly.
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Adding long-term care protection. Moving cash value from an existing life policy into a hybrid life/long-term care contract lets you repurpose a policy you may no longer need for its original death-benefit purpose, without triggering tax on the gain. Money not used for long-term care still passes to beneficiaries as a death benefit.
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Switching the type of life insurance. For example, moving from a policy built around accumulating cash value into one built around maximizing the death benefit, such as guaranteed universal life.
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Lower fees or different features. A newer policy may offer better internal costs or different investment options than one purchased years earlier.
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Consolidating multiple policies. Combining several older policies that no longer make sense individually into one larger, more efficient contract.
What It Actually Costs
A 1035 exchange isn’t a free do-over. Before doing one, it’s worth understanding what you’re taking on:
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New underwriting for a life insurance exchange. Health changes since your original policy was issued can mean higher costs on the new policy, and age alone can push rates up.
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A new surrender period. Many cash-value policies charge fees for cashing out in the early years — sometimes for as long as 20 years. A 1035 exchange into a new policy typically restarts that clock, which can limit access to the money for years if the new policy doesn’t perform as expected.
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New up-front fees and commissions, which reduce the value actually transferred into the new contract.
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A new two-year contestability period, during which the new insurer can review your application closely and potentially deny a claim if it finds a misstatement.
A Red Flag Worth Knowing
If an agent recommends a 1035 exchange while showing you a policy illustration with more attractive projected returns, it’s worth asking pointed questions before proceeding: what the projections are actually based on, what’s guaranteed versus assumed, what new up-front fees apply, and whether the agent earns a new commission on the sale. Some exchange recommendations are driven more by the commission on a new sale than by an actual change in your needs — a pattern worth watching for with any life insurance recommendation, not just this one.
FAQ
What products qualify for a 1035 exchange?
You can make a like-kind exchange under Section 1035: a cash-value life insurance policy can move into another life insurance policy or into an annuity, and an annuity can move into another annuity. What you can’t do is exchange an annuity into life insurance — that direction doesn’t qualify for tax-free treatment.
Do I need a medical exam when exchanging life insurance?
Generally yes. Exchanging into a new life insurance policy means going through underwriting again, which can include a medical exam. The 1035 exchange makes the cash-value transfer tax-free — it doesn’t simplify or skip the application process for the new policy itself.
Will surrender charges apply in a 1035 exchange?
They can. If you’re exchanging one cash-value life insurance policy into another, surrender charges on the original policy may apply, which means less of your cash value actually makes it into the new contract. You’ll also typically start a new surrender-charge period on the new policy.
How is a partial 1035 exchange different?
A partial 1035 exchange moves only part of the cash value into a new policy or annuity, rather than the whole contract. This can make sense if you want to keep some life insurance coverage in place while converting a portion of the cash value to an annuity, for example. The original policy’s death benefit and cash value decrease accordingly, but the portion that moves does so tax-free.
Questions Worth Asking
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Has your actual need changed — from a death benefit to income, or toward long-term care protection — or is the current policy still doing its original job?
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What would a new surrender period and new underwriting actually cost you, compared to the tax you’re avoiding by exchanging rather than surrendering?
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If you’re exchanging into a new life insurance policy, has your health changed since the original policy was issued in a way that could affect new underwriting?
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Is the person recommending this exchange showing you guaranteed figures or projected ones, and do they benefit from a new commission if you proceed?
What To Do Next
If you’re holding a life insurance policy or annuity that no longer fits your current needs, let’s look at whether a 1035 exchange actually makes sense for your situation — including the real costs, not just the tax deferral.
Questions? Call (800) 927-9326 or email
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Sources: Kimberly Lankford, “1035 Exchange: How to Switch Tax-free to a New Life Insurance Policy or Annuity,” Buy Side from WSJ (updated September 23, 2026), with commentary from Jack Elder (CBS Brokerage) and Steven J. Gibson, CFP (Plante Moran).
This article is for general educational purposes and is not personalized financial or tax advice. Tax treatment of 1035 exchanges depends on your specific contracts and circumstances — consult a qualified tax advisor before proceeding. This is not a recommendation regarding any specific product or carrier. Consult a licensed advisor for guidance specific to your situation.
