What is a 1035 exchange and when should you use one?

Section 1035 of the Internal Revenue Code lets you exchange one life insurance policy or annuity for another without triggering income tax on the gain. It is a tax-deferred swap, similar in concept to a 1031 exchange for real estate. Used correctly, it can save you a meaningful amount of money. Used badly, it is one of the most common ways agents generate new commissions at the client's expense.

Exchanges the IRS allows

• Life insurance to life insurance
• Life insurance to annuity
• Annuity to annuity
• Life insurance or annuity to long-term care insurance (within specific rules)

You cannot exchange an annuity for a life insurance policy. The IRS allows tax-free movement in one direction only — from insurance toward annuity, never the reverse.

When a 1035 exchange genuinely makes sense

• Your current policy is underperforming and a better-priced product is available
• Your health has improved enough to qualify for a meaningfully lower premium
• Your current product is no longer needed — for example, exchanging a permanent policy you no longer need for an annuity that creates retirement income
• Your current carrier has weakened financially and you want to move to a stronger one

When a 1035 exchange is being sold for the wrong reasons

• The agent stands to earn a fresh commission on the new contract
• The new contract has a longer surrender period than the old one, locking up your money again
• The benefits being promised in the new contract are similar to what you already have
• Your old contract still has years of surrender charges that you would lose by exchanging

What to do before agreeing to one

1. Ask for an in-force illustration on your current policy or annuity
2. Ask for a comparison illustration on the proposed new product
3. Ask in writing what commission the agent will earn on the exchange
4. Ask what surrender charges, if any, you would forfeit by leaving the old contract
5. Take both illustrations to an independent financial planner or fee-only advisor for a second opinion

Keep both the old and new contracts in your EverKeep vault, along with the comparison illustrations. If anyone questions the exchange later, you have the paper trail in one place.