Which of the following enables a life policy to be replaced with another life policy and results in the postponement of the tax consequence?

• A. Section 1035 exchange
• B. Nonforfeiture option
• C. Reinstatement clause
• D. Grace period

Answer: (A)

A Section 1035 exchange lets you replace a life insurance policy with another life policy without triggering taxes on any gains at the time of the swap. The idea is to move the existing policy’s cash surrender value into a new policy, carrying over the policy’s basis so you don’t realize a gain now. Since no money is paid out to you in the exchange, the tax consequence is postponed until a later event—such as surrendering the new policy for cash, taking withdrawals, or the death benefit being paid.

For a 1035 exchange to qualify, the transfer must be a direct move from one insurer to another (or within the same insurer) and must involve like-kind contracts—specifically life insurance or annuity contracts. The policyowner should not receive any money as part of the exchange, or the tax deferral benefit may not apply.

The other options address different policy features (nonforfeiture options deal with what happens if premiums stop; reinstatement lets you bring a lapsed policy back within a window; grace period extends the time to pay premiums) and do not provide tax deferral on replacing a policy.