By Marc Gilman
Questions? Call (800) 927-9326 or email
Key Takeaways
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A 1035 exchange lets you move cash value from one policy to another without triggering income tax on any gains — named after the tax code section that allows it.
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It only works in certain directions: life insurance to another life insurance policy, life insurance to an annuity, or annuity to another annuity. You cannot 1035 exchange an annuity into a life insurance policy, and the rule doesn’t apply to term life insurance, which has no cash value to move.
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Taxes are deferred, not eliminated. Your original cost basis carries over to the new policy, so a future surrender or large withdrawal can still trigger a tax bill later.
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The exchange itself is tax-free, but the new policy usually isn’t cost-free. New sales commissions, fees, a fresh surrender schedule, and — for life-to-life exchanges — new underwriting are the real price of switching.
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A 1035 exchange from life insurance to an annuity skips new health underwriting entirely — a meaningful difference from a life-to-life exchange, where your current health and age get fully re-evaluated.
What a 1035 Exchange Actually Is
If you have a permanent life insurance policy with cash value that’s grown over the years, cashing it out triggers income tax on everything above what you originally paid in — your cost basis. A 1035 exchange offers a way around that immediate tax bill: you can transfer the cash value directly into a new policy or an annuity without paying tax at the time of the switch.
That deferral isn’t a tax elimination, though. Your original cost basis carries forward into the new contract, so if you eventually surrender the second policy or take a large withdrawal, the accumulated gain can still be taxed at that point. And if you die with the policy in force, your beneficiaries receive the death benefit tax-free regardless of whether a 1035 exchange ever happened.
What’s allowed:
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Life insurance → another life insurance policy
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Life insurance → an annuity
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Annuity → another annuity
What’s not allowed: an annuity cannot be 1035 exchanged into a life insurance policy, and term life insurance doesn’t qualify at all, since it never builds cash value.
How the Exchange Actually Works
The cash value has to move directly from the old carrier to the new one — you never take possession of the money yourself. It typically gets applied to the new policy as a single, lump-sum premium deposit, even if the new policy’s ongoing structure looks completely different going forward.
One detail that surprises people: doing a 1035 exchange doesn’t skip the application process for the new policy. If you’re exchanging into another life insurance policy, you go through full underwriting again — the new insurer evaluates your current health and other risk factors just as if you were buying a brand-new policy with fresh money. That matters most for older policyholders or anyone whose health has changed since the original policy was issued.
The one exception: exchanging a life insurance policy into an annuity does not require new health underwriting.
Five Common Reasons People Use a 1035 Exchange
1. You need retirement income more than a death benefit. A policy purchased decades ago to replace lost income at death may no longer match what you actually need heading into retirement — sometimes people find they need more income than the policy can sustain, or the death benefit itself simply isn’t necessary anymore. Exchanging into an annuity redirects that accumulated value toward income instead.
2. You want long-term care coverage built into your policy. A common use of a 1035 exchange moves cash value from an existing life policy into a linked-benefit or hybrid life insurance/long-term care policy — coverage that can help pay for care in a nursing home, assisted living facility, or at home if you need help with at least two activities of daily living, or have a severe cognitive impairment. Money not used for long-term care still passes to your beneficiaries as a death benefit.
3. You want a different type of life insurance entirely. Someone with a policy built around accumulating cash value might exchange into a policy designed to maximize the death benefit instead — a guaranteed universal life policy, for example — sometimes significantly increasing the benefit in the process.
4. You want lower fees or different investment options. Moving from a whole life policy into a variable universal life policy, for instance, shifts you from guaranteed returns toward mutual-fund-like investment accounts with different cost and growth profiles.
5. Consolidation. If you’re holding multiple policies that no longer make sense individually, combining them into a single, larger policy can simplify management and reduce overall cost.
What a 1035 Exchange Actually Costs You
The tax-free part is real, but it’s rarely the whole picture. Before exchanging, weigh these costs directly:
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New underwriting (life-to-life exchanges only). Health changes since your original policy was issued — or simply being older now — can mean a higher insurance cost on the new policy than you’re paying today.
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A brand-new surrender period. Many cash-value policies charge steep fees for surrendering early — sometimes for the first 20 years. A 1035 exchange doesn’t carry over time already served; the new policy starts its surrender clock from zero, which can limit access to your money for years if circumstances change or the new policy underperforms.
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New up-front fees and commissions. These reduce the new policy’s effective value from day one.
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A new two-year contestability period. During this window, the insurer can investigate your application closely and deny a claim if it finds a misstatement — a real risk if your new application isn’t complete and accurate.
A Word of Caution
If an agent shows you an illustration promising better investment returns in a new policy, ask specifically what those projected numbers are actually based on, what portion is guaranteed versus projected, what new up-front fees apply, and whether the agent earns a new commission from making the switch. A 1035 exchange genuinely helps some people — but it also generates a new sale, and it’s worth being clear-eyed about which motivation is driving the recommendation.
Questions Worth Asking
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Does your current policy still match what you actually need today — income, death benefit, long-term care — or has your situation changed since you bought it?
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If you’re considering a life-to-life exchange, has your health changed enough since the original policy that new underwriting could raise your costs?
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Have you confirmed exactly what surrender period, fees, and commissions apply to the new policy before agreeing to the exchange?
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If someone is recommending an exchange based on a rosy illustration, have you asked what’s actually guaranteed versus projected?
What To Do Next
If you have an old life insurance policy or annuity that no longer fits your situation, let’s go through whether a 1035 exchange actually makes sense for you — including the real costs, not just the tax deferral — before you commit to anything.
Questions? Call (800) 927-9326 or email
Prefer we reach out to you instead? Complete our Permission to Contact form and a licensed Gilman Agency agent will follow up.
Sources: Buy Side from WSJ, “1035 Exchange: How to Switch Tax-free to a New Life Insurance Policy or Annuity” by Kimberly Lankford (updated March 2026), including commentary from Jack Elder, head of advanced sales at CBS Brokerage, and Steven J. Gibson, CFP, president of Plante Moran’s life insurance agency; Internal Revenue Code Section 1035.
This article is for general educational purposes and reflects information available as of the publication date. Surrender periods, fees, underwriting requirements, and tax treatment vary by policy, carrier, and individual circumstances — always review your specific contract and confirm current details directly with the carrier. This is not a recommendation regarding any specific product, and is not tax or legal advice. Consult a licensed advisor for guidance specific to your situation.
