Life Insurance✓ Verified · outline & fact-checked · Sep 2026Difficulty 2/5
Which of the following exchanges of contracts is generally tax-free under IRC Section 1035?
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Answer & full 3-part explanation (select an option above, or peek)
Why A is correct
IRC Section 1035 allows a tax-free exchange of one life insurance policy for another life policy, a life insurance policy for an annuity, or one annuity for another annuity, provided the same policyowner is involved and no money is taken out of the transaction. A life-for-life exchange is squarely within the statute and lets policyowners upgrade coverage without recognizing taxable gain. The purpose of the provision is to allow policies to be modernized without triggering a tax event on accumulated gain.
Why the other options are wrong
- B) Exchanging an insurance contract for a taxable investment asset such as a certificate of deposit is a taxable disposition, not a Section 1035 exchange. No gain is recognized as long as the exchange involves no cash withdrawal or change of owner.
- C) The exchange of an annuity for a life insurance policy is not tax-free under Section 1035; only the reverse direction, life to annuity, is allowed. A CD is not an insurance contract, so the exchange is treated as a surrender followed by a new investment.
- D) Taking cash out of an exchange triggers taxation on the amount received; a fully tax-free exchange involves no cash or boot. The statute permits life-to-annuity and annuity-to-annuity, but not annuity-to-life exchanges.
Memory hook
1035 flows: life to life, life to annuity, annuity to annuity. Annuity to life is the one-way door you cannot open.