The 1035 exchange

What a 1035 exchange does

Ending a whole life policy for cash taxes whatever the cash value holds above what you paid in. Section 1035 of the tax code offers another route. The value goes straight from the old insurer to the new contract, and no gain is recognized on the trade, provided the new contract is of an allowed kind. Kitces lists those kinds as another life insurance policy, an annuity or a long-term care policy^[1].

Two people may not change. The owner must remain the same, per Northwestern Mutual^[2], and a law firm reprint adds that neither the owner nor the insured may differ after the exchange^[3]. So a policy cannot be exchanged into a contract on your spouse or into a trust's name in the same step.

This page is general information about how the rule works. Whether an exchange is taxable in your case is a question for a tax professional.

Which way the money can move

The direction rule is one-way. Northwestern Mutual puts it plainly. Life policies can go to life policies, permanent life can go to a non-qualified annuity, and a non-qualified annuity cannot come back into permanent life insurance^[2].

Checked November 10, 2026. Directions as stated by Northwestern Mutual (August 14, 2023) and Kitces (2025). Owner and insured stay the same in every case.

The annuity direction gets its own page, whole life to an annuity, because it ends the death benefit and changes how withdrawals are taxed.

Your basis comes with you

Basis is what the tax code treats as your own money in the policy. Kitces defines it for this purpose as premiums paid, minus any partial surrenders or cash dividends received, and says that figure carries over as the basis of the new contract^[1]. The law firm reprint says the same for a life to life exchange^[3].

That has two effects. The untaxed gain is not forgiven, only postponed into the new contract. And dividends you took in cash over the years, which were not guaranteed in any year, lowered your basis, so a policy that paid cash dividends for decades may hold more gain than its owner expects. Your insurer can state the cost basis on request.

The loan problem, when part of the policy turns into boot

Boot is anything in an exchange that is not like-kind property. Cash handed to you is boot. So is a loan that vanishes. Windsor Insurance explains that if a policy with a loan is exchanged and the loan is not carried over, the disappearing loan is treated as a distribution and taxed to the extent of gain in the original policy^[4]. Kitces says the same of a loan paid off with the policy's own cash value as part of the exchange^[1]. The taxable amount is the lesser of the boot and the gain.

The second case is larger. Windsor describes an owner with $300,000 of basis, $550,000 of gross cash value and a $200,000 loan, who moves only the $350,000 net value. The gain is $250,000 and the loan is $200,000, so the whole loan, $200,000, is taxable boot, which Windsor puts at $80,000 of tax in a 40% bracket^[4]. The owner received no cash and still owes the tax.

The worksheet on the 1035 exchange calculator runs the same arithmetic on your own statement figures.

Getting rid of the loan first, and the step transaction risk

There are three ways out, and each has a condition.

1. Pay the loan with outside money. Kitces says repaying from funds outside the policy can be done at any time before the exchange, because nothing is withdrawn from the policy^[1].
2. Pay it from the policy, well ahead. A withdrawal well before the exchange is taxed first-in, first-out, so it comes out of basis first. Done as part of, or immediately before, the exchange, Kitces says it is boot instead. There is no fixed waiting period. Kitces suggests separate tax years and a real purpose for the money^[1].
3. Carry the loan over. Windsor reports that private letter rulings 8806058 and 8604033 approved moving the loan to the new policy, and that 9141025 went the other way, treating a withdrawal to repay the loan just before the exchange as a step transaction^[4]. Whether a new insurer accepts a loan is its own choice. The law firm reprint says most insurers will not carry one over^[3], and Kitces says not all annuity carriers permit it^[1].

Letter rulings bind only the taxpayer who asked for them. Windsor reports them, and we report them as Windsor does. We did not open the rulings.

MEC status follows the money

A modified endowment contract, or MEC, is a policy funded past the 7-pay limit, the line BetterWealth describes as the point where a policy would lose its tax advantages^[6]. An exchange does not wash that status away. Insurance & Estates says that if the original policy is a MEC, the exchanged policy is also deemed one^[7], and the law firm reprint calls the new policy automatically a MEC^[3]. Ask the old insurer in writing whether the policy is a MEC before you start.

Before you exchange, what you give up

An exchange is a replacement, and keeping the policy you have is sometimes the better answer. Weigh these first.

• New surrender charges. Kitces notes that withdrawals in the first 7 to 10 years of an annuity are likely to carry surrender charges^[1].
• Annuity taxes run the other way. Annuity withdrawals are taxed gain first, and before age 59 and a half an extra 10% tax can apply unless an exception fits^[1].
• The death benefit. Moving into an annuity ends the life coverage. If anyone still depends on it, that loss outweighs a better crediting rate.
• Unpaid loans. Settle how the loan will be handled before any paperwork, using the steps above.

Questions people ask

Last updated November 11, 2026. Found an error? Tell us and it goes in the corrections log.