What Is a 1035 Exchange? Definition, Rules & Lessons for Australians

Ever heard of a ‘1035 exchange’ and wondered what it actually means? While the term is rooted in US tax law, the concept offers valuable insights for Australians thinking about tax efficiency and financial product flexibility. As 2025 brings fresh perspectives on superannuation and investment regulations in Australia, understanding global strategies is more relevant than ever.

Breaking Down the 1035 Exchange: What Is It?

A 1035 exchange is a provision in the US Internal Revenue Code that allows policyholders to swap one life insurance policy or annuity for another—without triggering immediate tax consequences. The goal? To let people upgrade or shift their financial products as needs and markets change, while deferring any tax hit until money is withdrawn. In other words, it’s a legal way to roll over certain insurance or annuity contracts and keep your tax bill at bay.

Key features include:

• No immediate tax due: Gains are rolled into the new policy or contract.
• Like-for-like requirement: You can exchange a life insurance policy for another life policy or annuity, but not for cash.
• Direct transfer: Funds must go directly from one insurer to another—no personal receipt of funds allowed.

For example, if an American has a whole life policy with high fees, they could switch to a more modern, lower-cost policy through a 1035 exchange, keeping the tax benefits intact.

How Do 1035 Exchange Rules Work? 2025 Updates and Practicalities

The rules around 1035 exchanges are specific and tightly regulated. Here’s a breakdown of the main mechanics and what’s new for 2025:

• Eligible products: Life insurance to life insurance, life insurance to annuity, and annuity to annuity exchanges are permitted. However, annuity to life insurance is not allowed.
• Same policyholder: The owner and insured must remain the same on both policies.
• Cost basis tracking: The original cost basis carries over to the new contract, preserving the tax history.
• Partial exchanges: Since 2023, partial 1035 exchanges are closely scrutinised, with IRS guidance emphasising clear, direct transfers and anti-abuse measures.
• 2025 policy updates: The IRS recently clarified digital and electronic authorisations for 1035 exchanges, making the process smoother and faster—a move that echoes digital onboarding trends in Australia’s financial sector.

Example: Jane, a US investor, has a variable annuity with poor performance. In 2025, she uses a 1035 exchange to move her funds to a lower-fee, ESG-focused annuity, keeping her tax advantages while aligning with her values.

Australian Context: Can We Learn from the 1035 Exchange?

Australia doesn’t have a direct equivalent to the 1035 exchange, but the principle—tax-efficient rollover of financial products—is highly relevant. Australians often face exit fees, loss of bonuses, or tax implications when moving between super funds, annuities, or insurance products. The US model offers food for thought as our own regulators review product portability and consumer choice in 2025.

Key takeaways for Australians:

• Superannuation portability: The Australian government is considering further reforms to make it easier to consolidate or switch super funds without penalty. Lessons from the 1035 exchange could support more seamless, tax-neutral transitions.
• Annuity innovation: With longevity and retirement income front-of-mind, the US experience with tax-advantaged annuity swaps may inspire local policy tweaks.
• Insurance flexibility: As digital-first insurers emerge in Australia, the push for easier, penalty-free upgrades or changes is gaining momentum.

Real-world scenario: If Australia introduced a similar provision, retirees could move from legacy annuities into modern, flexible products as their circumstances change—without triggering tax or losing accrued benefits.

Key Considerations Before Any Exchange

• Always evaluate the fees, surrender charges, and policy features before making a switch.
• Understand how cost basis and capital gains are treated in both your current and new product.
• Consult product disclosure statements and stay up to date with 2025 regulatory changes—especially as Australia’s Treasury reviews super and retirement income rules.

Conclusion: Watch This Space for Australian Reforms

While a 1035 exchange is uniquely American, the core idea—making financial products more flexible, portable, and tax-efficient—is sparking debate in Australia. As the government looks to modernise superannuation and insurance rules in 2025, expect more discussion about how to empower consumers with better rollover and upgrade options. Staying informed on global best practices could give you an edge as Australia’s financial landscape evolves.