Why Doctors Must Take Care When Swapping Insurance Policies and Annuities

Understanding Section 1035 Treatment of Exchanges

By Dr. David Edward Marcinko MBA CMP™



With the passage of the Tax Equity and Fiscal Responsibility Act, back in 1982 (TEFRA), insurance companies were required to report the payment of all surrender proceeds, forcing physicians and all individuals to be more compliant in reporting gains on the surrender of an old policy. As a result, insureds took advantage of IRC Section 1035 and made tax-free exchanges of insurance, endowment, and annuity contracts. If the exchange is structured properly, gains (and losses) on the surrender of an old policy must be deferred beyond the life of the policyholder.

Section 1035 Treatment

The following types of exchanges qualify for tax-free treatment:

1. A life insurance contract for another life insurance, annuity, or endowment contract

2. An endowment contract for an annuity contract or for another endowment contract in which the payments begin at a date no later than the date that payment would have begun under the original contract

3. An annuity contract for another annuity contract

However, to the extent that money or other property (“boot”) is received by the insured in a 1035 exchange, gain may be recognized to the extent of the “boot.” The new policy received takes the basis of the old contract exchanged, decreased by the value of boot received, and increased by any gain required to be recognized.


Unlike exchanges subject to Section 1031, in which there is a 180-day limit, there is apparently no statutory time limit for completing an exchange under Section 1035. However, be careful in the case of an exchange of immediate annuity contracts in which the annuity starting date must begin no later than one year from the date of the purchase of the annuity. When an exchange has occurred, the holding period of the original contract attaches to the new contract. Therefore, the insured may not have begun to receive the annuity within one year from the date of the annuity’s purchase, and therefore, the 10% premature withdrawal penalty may apply.

Section 403(b) Annuities

The IRS has even allowed tax-free exchange of Section 403(b) annuities provided the new contract’s distribution restrictions are at least as stringent as those of the old contract. And, distributions from financially troubled life insurance companies, if reinvested within 60 days of receipt, can qualify for 1035 treatment. But, in most cases, a doctor or taxpayer should undertake a direct exchange whenever possible.

Note: “Nontaxable Exchanges of Insurance Contracts and Annuities Under Section 1035,” John C. Zimmerman and Tamara K. Kowalczyk, Journal of Taxation of Investments, Summer 1997, pp. 307–315, Warren, Gorham & Lamont, (800) 950-1205.


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