To report a 1035 exchange on Form 1040, enter the gross distribution from Box 1 of your Form 1099-R on Line 5a and enter $0 on Line 5b, provided Box 7 shows distribution Code 6 and Box 2a shows zero. That is the whole entry for a clean, fully tax-free exchange. Everything else is verifying the 1099-R before you file and keeping records that prove your basis later.
Verify Your 1099-R Before You Touch the 1040
After the exchange closes, the surrendering carrier issues a Form 1099-R. That document drives your return, and reading it correctly matters more than any other step.1Internal Revenue Service. 2025 Form 1099-R – Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc.
For a properly executed Section 1035 exchange, the form should show:
- Box 1 (Gross Distribution): the total value of the contract transferred to the new carrier.
- Box 2a (Taxable Amount): zero. The IRS instructions require issuers to enter $0 for a nontaxable Section 1035 exchange.
- Box 5 (Employee Contributions): the total premiums you paid into the old contract, which is your cost basis.
- Box 7 (Distribution Code): Code 6, which specifically identifies a Section 1035 exchange of insurance contracts.
Code 6 is the pivot. Code G, which looks similar in casual advice, applies to direct rollovers from qualified retirement plans like 401(k)s and does not belong on a 1035 exchange.2Internal Revenue Service. 2025 Instructions for Forms 1099-R and 5498 If your 1099-R shows Code 7 (normal distribution), Code 1 (early distribution), or anything other than 6 on a transaction that was meant to be a 1035 exchange, call the issuing carrier before you file and request a corrected form. Filing with the wrong code creates a mismatch the IRS automated matching system will flag, and you will receive a notice proposing tax on the entire Box 1 amount.
Entering the Exchange on Lines 5a and 5b
With a correct 1099-R in hand, the Form 1040 entry is short.3Internal Revenue Service. 1040 (2025) Instructions
- Line 5a (Pensions and annuities, gross): enter the full amount from Box 1 of your 1099-R. This acknowledges the transaction to the IRS.
- Line 5b (Taxable amount): enter $0. If Box 2a on your 1099-R is blank rather than showing a zero, still enter $0 on Line 5b.
The IRS sees a large figure on Line 5a and zero on Line 5b. Without context, their automated systems may generate an inquiry. Many tax professionals write “1035 EXCHANGE” next to Line 5b to head off that notice. The annotation is not explicitly required by the Form 1040 instructions, but it is a low-effort step that can save months of correspondence.
Some practitioners also attach a brief statement to the return identifying the old and new carriers, both contract numbers, the gross distribution amount, and the transfer date. That is especially useful on paper-filed returns or when the exchange involved multiple contracts, because it provides a clear paper trail if the IRS later questions the zero on Line 5b.
The matching system compares every 1099-R the IRS receives against the corresponding Form 1040. A large Line 5a paired with a zero Line 5b and no explanation is one of the more common triggers for a CP2000 notice proposing additional tax. A CP2000 is not an audit; it is a computer-generated letter. But responding still means gathering the original exchange documentation, which is far easier at filing time than two years later.
When Box 2a Is Not Zero: Boot
A 1035 exchange is tax-free only when you receive nothing but the new contract. If you received cash or other property alongside the new contract, that extra amount is “boot.” Under Section 1035(d), which cross-references Section 1031(b), you recognize gain up to the amount of boot received.4Office of the Law Revision Counsel. 26 USC 1031 – Exchange of Real Property Held for Productive Use or Investment
If the old contract held $30,000 in gain and you received $5,000 in cash, you recognize $5,000 of ordinary income, the lesser of the gain and the boot. If the boot had exceeded the gain, you would be taxed only on the gain.
The carrier should report the taxable boot in Box 2a of the 1099-R. On Form 1040, Line 5a still shows the full gross distribution from Box 1, and Line 5b shows the taxable portion from Box 2a. That taxable portion is ordinary income. Attaching a short statement explaining the partial taxability reduces the chance of an IRS inquiry on the mixed figure.
Partial 1035 Exchanges
A partial 1035 exchange transfers only a portion of one annuity contract’s cash surrender value into a new annuity contract. The IRS did not formally bless this arrangement until Revenue Procedure 2011-38, and the rules come with a condition: you generally cannot take a withdrawal from either contract within 180 days of the transfer.5Internal Revenue Service. Revenue Procedure 2011-38
If you take any amount from either contract during that 180-day window, other than annuity payments spread over 10 years or more or over one or more lives, the IRS will recharacterize the transfer based on its substance. In practice that usually means treating it as a taxable partial surrender followed by a new contract purchase, which wipes out the tax-free benefit.
For reporting, a partial exchange works the same way as a full one on Form 1040. The carrier issues a 1099-R for the transferred portion with Code 6 and $0 in Box 2a; you report Box 1 on Line 5a and $0 on Line 5b. Keep records of both contracts and mark the 180-day date on your calendar.
If the 1099-R Is Wrong or the Exchange Failed
An exchange that does not meet the Section 1035 requirements is treated as a full surrender of the old contract. The entire gain above your cost basis becomes ordinary income in the year of the distribution. The carrier should issue a 1099-R with a code other than 6, typically Code 7 for a normal distribution or Code 1 if you are under 59½, and Box 2a will show the taxable gain. Report Box 1 on Line 5a and Box 2a on Line 5b.3Internal Revenue Service. 1040 (2025) Instructions
If you are under 59½ when a failed exchange is treated as an annuity distribution, an additional 10% penalty under IRC Section 72(q) applies to the taxable amount on top of ordinary income tax. If the understatement is large enough, the IRS can also impose a 20% accuracy-related penalty under Section 6662.6Office of the Law Revision Counsel. 26 U.S. Code 6662 – Imposition of Accuracy-Related Penalty on Underpayments If you believe the carrier issued the wrong code and the exchange did qualify, request a corrected 1099-R rather than filing against the incorrect one and sorting it out later.
Keep the Records That Prove Your Basis
The tax-free treatment rests on basis carryover. Your investment in the old contract transfers to the new one dollar for dollar. Section 1031(d), which applies to 1035 exchanges through the cross-reference in Section 1035(d), sets the new contract’s adjusted basis equal to the old contract’s basis, decreased by any cash received and adjusted for any recognized gain or loss.7Internal Revenue Service. Notice 2011-68 – Annuity Contracts
That creates a record-keeping obligation that can last decades. When you eventually surrender the new contract or begin receiving annuity payments, you will need to prove your basis to avoid being taxed on money you already paid tax on. Keep a permanent file containing:
- The original contract application and premium records, which establish your initial investment.
- The Form 1099-R with Code 6, which documents that the exchange was reported as nontaxable.
- The new contract’s policy documents, which confirm the receiving carrier and contract terms.
- Any statement you attached to your Form 1040, which supports your reporting position.
If you have done multiple 1035 exchanges over the years, trading Contract A for Contract B and then Contract B for Contract C, the basis chain runs all the way back to Contract A. Losing the original premium records at any link means you may not be able to prove basis when the final distribution occurs, and the IRS will tax the entire payout as ordinary income. The exchange that feels like a routine paperwork step today becomes a critical tax document twenty years from now.