Can You Do a Partial 1035 Exchange? Cost Basis and the 180-Day Rule

A partial 1035 exchange lets you move a portion of a non-qualified annuity or life insurance contract into a new qualifying contract without owing income tax on the transfer. Revenue Procedure 2011-38 sets the ground rules: the transfer must go directly from carrier to carrier, cost basis splits proportionally between the two contracts, and you generally can’t pull money from either contract for 180 days afterward.¹

Which Contracts You Can Exchange

Section 1035 of the Internal Revenue Code allows tax-free exchanges only in specific directions.² The permitted combinations are:

Life insurance to life insurance.
Life insurance to an annuity.
Annuity to annuity.
Any of the above into a qualified long-term care contract.³

The one direction that never works is annuity to life insurance. Treasury regulations state plainly that Section 1035 “does not apply to transactions involving the exchange of an endowment contract or annuity contract for a life insurance contract.”⁴ Try it anyway and the IRS treats the whole thing as a taxable distribution. A contract with a long-term care rider built in still qualifies on its own.

One boundary worth knowing up front: Section 1035 covers only non-qualified contracts, meaning policies and annuities bought with after-tax dollars outside a retirement plan. If your annuity sits inside an IRA, 401(k), or 403(b), you’re in a different world governed by rollover rules, not 1035.⁵

Same Owner, Same Insured

The owner and the insured (or annuitant, on an annuity) must be the same person on both the old and the new contract. The regulation requires “the same person or persons” to be the obligee under each contract, and does not apply to exchanges where the policies “do not relate to the same insured.”⁴

You can’t take a single-life policy on one spouse and exchange it into a survivorship policy covering both. The IRS has ruled against that. If you want a change in owner or insured, complete the exchange first with matching names, then make ownership changes afterward on the new contract.

How Cost Basis Splits

In a partial exchange, your basis moves proportionally with the money. Transfer 50% of the cash value and 50% of the basis follows; transfer 25%, and 25% of the basis follows.¹

Here’s the math with real numbers. You own an annuity worth $100,000 with a $60,000 cost basis, and you move $50,000 into a new contract. That’s 50% of the value, so 50% of the basis goes with it. The new contract starts with $30,000 in basis; the original keeps $30,000. Had you transferred $25,000 instead, only $15,000 in basis would move. This allocation drives how much of any future withdrawal from either contract counts as taxable gain versus a return of your own money, so it’s worth confirming in writing with both carriers.

The 180-Day Rule

Revenue Procedure 2011-38 imposes a 180-day waiting period after the partial exchange completes. If you take a distribution from either contract inside that window, the IRS can recharacterize it, either as “boot” in the exchange or as a taxable distribution under the standard annuity rules.¹

If you’re under 59½, the taxable portion also picks up a 10% early withdrawal penalty under Section 72(q).⁶ The rule exists to stop people from using partial exchanges as a workaround for tax-free withdrawals.

Annuitization Exception

One carve-out matters if you’re near or in retirement. The 180-day restriction doesn’t apply to amounts received as annuity payments over a period of 10 years or more, or over one or more lifetimes. Immediately annuitize the new contract into a qualifying income stream and those payments won’t jeopardize the tax-free treatment.¹ That’s what makes partial exchanges practical when you want to convert part of a deferred annuity into immediate lifetime income.

What Beneficiaries Lose in a Life-to-Annuity Move

Life insurance death benefits are generally received income-tax-free. Annuity death benefits are not: beneficiaries owe income tax on the earnings portion of any annuity they inherit. Moving cash value out of a life insurance policy into an annuity converts a tax-free inheritance into a taxable one.

The trade can still make sense if you no longer need the death benefit coverage and want lifetime income or better growth. Just recognize it’s a one-way door. Once the funds sit in an annuity, you cannot exchange them back into life insurance.

How the Transfer Actually Moves

The funds have to go directly from the old carrier to the new one. If a check gets cut to you personally at any point, the IRS treats the whole thing as a taxable distribution rather than a 1035 exchange.²

Timing varies by carrier. Most transfers wrap up in three to four weeks. Insurance companies have up to six months before they’re required to send the funds, so don’t count on speed. Watch both accounts and follow up if you haven’t seen confirmation within a month.

Accuracy on the paperwork matters. Owner name, annuitant name, and Social Security number must match exactly between the old and new contracts. Small discrepancies get transfers rejected, which by itself doesn’t create a tax problem but does create delays that can collide with the 180-day rule if you’ve already started taking distributions.

What Your 1099-R Should Show

The original carrier issues a Form 1099-R for the year of the transfer. On a properly executed tax-free exchange, Box 2a (taxable amount) should read zero, and Box 7 should carry distribution Code 6, the code for a Section 1035 exchange.⁷ If part of the transaction is taxable, whether from boot or a 180-day violation, the carrier files a separate 1099-R for the taxable amount.

Check the form when it arrives. If Box 2a shows a taxable amount and you believe the exchange was fully tax-free, call the issuing carrier immediately. Fixing a 1099-R before you file is far easier than amending afterward. Ask both carriers for statements confirming the transferred amount and the basis allocation, and keep them.

Surrender Charges Still Apply

A partial 1035 exchange sidesteps income taxes. It doesn’t sidestep surrender charges. If your current contract is still inside its surrender charge period, the carrier will typically deduct the applicable charge from the transferred amount before sending the funds. Those charges often run between 5% and 8% in the early contract years and step down on a set schedule.

Pull out your surrender schedule before you request the exchange. Waiting a few months to clear the surrender period sometimes saves more than the new contract offers in return. Tax-free doesn’t mean cost-free.

1
Internal Revenue Service. Revenue Procedure 2011-38
2
Office of the Law Revision Counsel. 26 USC 1035 – Certain Exchanges of Insurance Policies
3
Internal Revenue Service. Annuity and Life Insurance Contracts with a Long-Term Care Insurance Feature
4
eCFR. 26 CFR 1.1035-1 – Certain Exchanges of Insurance Policies
5
Internal Revenue Service. Publication 575, Pension and Annuity Income
6
Office of the Law Revision Counsel. 26 USC 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts
7
Internal Revenue Service. Instructions for Forms 1099-R and 5498