A 1035 annuity exchange lets you swap one annuity contract for another, or for a qualified long-term care insurance contract, without paying tax on the gains that have built up inside the original. Section 1035 of the Internal Revenue Code treats the new contract as a continuation of the old one rather than a sale, so deferred growth carries forward untouched.1Office of the Law Revision Counsel. 26 USC 1035 – Certain Exchanges of Insurance Policies The tax-free treatment is not automatic, though. Ownership has to match, the money can never touch your hands, and only certain product-to-product conversions qualify.
What You Can Swap an Annuity For
The statute sets up a one-directional hierarchy. Life insurance has the most flexibility at the top, and each step down narrows what the contract can become:1Office of the Law Revision Counsel. 26 USC 1035 – Certain Exchanges of Insurance Policies
- Life insurance can go into another life policy, an endowment, an annuity, or a qualified long-term care contract.
- Endowment insurance can go into another endowment (paying no later than the original), an annuity, or a qualified long-term care contract.
- An annuity can go into another annuity or a qualified long-term care contract. Nothing else.
- Qualified long-term care insurance can only go into another qualified long-term care contract.
You can move down the list but never up. An annuity cannot become a life insurance policy. Attempting that conversion triggers a full taxable event, with every dollar of gain taxed as ordinary income. The rule exists so people cannot retroactively push tax-deferred annuity savings inside the income-tax-free death benefit of life insurance.
Within the annuity-to-annuity path, you have room to work. The statute says “annuity contract for an annuity contract” without distinguishing subtypes, so a deferred annuity can be exchanged for an immediate annuity. Retirees can move from accumulation to income without a tax hit.
The long-term care destination was added by the Pension Protection Act of 2006.2Internal Revenue Service. Notice 2011-68 Money you no longer need for retirement income can be moved into a contract covering nursing home care, assisted living, or home health services, with no tax on the exchange itself. Benefits later paid from that contract for qualifying expenses come out entirely income-tax-free.
Ownership Must Stay the Same
Federal regulations require the same person or persons to serve as the obligee under both the old and new contracts.3Internal Revenue Service. Revenue Ruling 2003-76 The contract owner and annuitant on the replacement have to match the original. Trying to transfer your annuity’s value into a contract owned by your spouse or child turns the transaction into a taxable distribution plus a separate new purchase, and every dollar of gain becomes taxable immediately.
When a trust owns the original annuity, the same trust has to own the replacement. Tax identification numbers must line up across both contracts. A mismatched TIN is one of the more common reasons trust-owned exchanges get rejected by the insurance company or, worse, reclassified as a taxable event by the IRS. Confirm the exact entity name and TIN before the transfer paperwork goes in.
The Money Cannot Pass Through Your Hands
Funds in a 1035 exchange must move directly between insurance companies. If the surrendering company writes a check payable to you personally, the exchange fails and the entire amount becomes a taxable distribution.3Internal Revenue Service. Revenue Ruling 2003-76 The check has to be payable to the new insurance company for the benefit of you as policyholder.
The receiving insurance company usually starts the process by sending exchange paperwork that authorizes the old company to surrender the contract. Before submitting anything, gather three items from your existing provider: your contract number, the current surrender value, and your established cost basis (total after-tax premiums paid). The receiving company needs that basis figure to track your future tax liability correctly. Get the old company’s mailing address or wire instructions too.
Once submitted, the old carrier liquidates the contract and wires or mails the funds directly to the new insurer, which issues your replacement contract. Keep the final statement showing a zero balance on the old contract and the opening statement on the new one.
Your Cost Basis Carries Over
Section 1035(d) applies the same basis rules used in like-kind property exchanges. The cost basis in your old contract — the total after-tax premiums you paid — becomes your basis in the new one.1Office of the Law Revision Counsel. 26 USC 1035 – Certain Exchanges of Insurance Policies You don’t start over, and you don’t lose track of what has already been taxed.
This matters when distributions eventually start. Only growth above your carried-over basis is taxable. Pay $100,000 in premiums into an annuity that grows to $150,000, exchange it, and your basis in the new contract is still $100,000. Later withdrawals are taxed as ordinary income only above that threshold.
One wrinkle can undo the tax-free treatment: an outstanding loan on the old contract at the time of exchange. The forgiven loan amount can count as taxable consideration received outside the exchange, and the insurance company will file a separate Form 1099-R for that portion.4Internal Revenue Service. Instructions for Forms 1099-R and 5498 Pay off any loan before initiating the exchange if you want the whole transfer to stay tax-free.
Partial Exchanges and the 180-Day Rule
You do not have to move the full value. Revenue Procedure 2011-38 allows partial 1035 exchanges, where a portion of one annuity’s cash surrender value transfers into a new contract while the original stays active.5Internal Revenue Service. Revenue Procedure 2011-38 It’s a way to diversify across carriers or product types without surrendering the entire position.
The catch: no withdrawals from either the old or the new contract for 180 days after the transfer.5Internal Revenue Service. Revenue Procedure 2011-38 Pull money from either side inside that window and the IRS looks at the substance of the transaction, likely reclassifying it. The rule stops people from splitting a contract and immediately withdrawing gains as if they’d been shielded by the exchange.
Annuity payments structured over 10 or more years, or over one or more lifetimes, don’t count against the 180-day restriction. If lifetime income payments were already running on the original contract, they can continue during the 180-day window.
When a partial exchange fails the test, the IRS applies general tax principles to figure out what really happened. The withdrawn amount typically ends up characterized as taxable boot or as a distribution under Section 72(e). Either way, plan your liquidity needs before starting a partial transfer.
What an Exchange Actually Costs
Tax-free is not cost-free. Surrender charges on the existing contract are usually the biggest hit. Most annuities impose declining penalties for early termination, often starting near 7% in year one and phasing out over six to eight years. Money leaving during that period pays the charge, shrinking what actually reaches the new company.
The replacement contract then starts its own surrender charge schedule from scratch. Even if you just finished a seven-year surrender period, the new carrier treats your exchanged funds as new money subject to a fresh set of declining charges. That effectively locks the money down for another multi-year stretch and can make a 1035 exchange a poor deal even when the new product looks better on paper.
Some states also charge premium taxes on annuity considerations that may apply to funds flowing into the new contract. The amounts are usually small but do reduce your transferred balance. Ask the receiving company whether a premium tax applies in your state.
Most state insurance regulators require agents to give you a written cost comparison before completing a replacement. The NAIC’s model replacement regulation calls for a signed notice detailing acquisition costs, surrender charges, and expense differences between old and new products.6National Association of Insurance Commissioners. Life Insurance and Annuities Replacement Model Regulation An agent pushing a 1035 exchange without walking through that side-by-side is a red flag.
How It Gets Reported to the IRS
When the exchange crosses between two different insurance companies, the surrendering company files Form 1099-R. A properly executed tax-free exchange shows:4Internal Revenue Service. Instructions for Forms 1099-R and 5498
- Box 1: total value of the contract.
- Box 2a: zero (no taxable amount).
- Box 5: total premiums paid (your cost basis).
- Box 7: distribution Code 6, which flags the transaction as a Section 1035 exchange.
If the exchange happens within the same insurance company and produces no taxable distribution, the company may skip the 1099-R entirely as long as it keeps records of your basis.4Internal Revenue Service. Instructions for Forms 1099-R and 5498 Any portion that turns out to be taxable, such as a forgiven loan, gets its own separate 1099-R.
Hold on to the old contract, the exchange paperwork, and every 1099-R. The IRS does not track annuity basis for you. Years later, if questions come up about basis in the new contract, the burden of proof sits with you.
What Happens if the Exchange Fails
An exchange that misses the requirements — wrong ownership, funds routed through your personal account, or a conversion the code doesn’t allow — turns the surrender of the old contract into a standard taxable distribution. All gains above cost basis are taxed as ordinary income in the year of the failed exchange.
Owners under age 59½ face compounding damage. Section 72(q) imposes an additional 10% penalty on early distributions from annuity contracts, on top of the regular income tax. The most common failure points are the same three every time: the policyholder takes temporary possession of the funds, ownership does not match between old and new contracts, or someone tries to convert an annuity into a life insurance policy. Each of these is preventable with clean paperwork and a clear understanding of the rules before anything gets signed.