A Section 1035 exchange lets you replace one annuity with another without paying income tax on the accumulated gains, but the tax rules for a 1035 annuity exchange are unforgiving: the new contract has to be a type the statute allows, the owner and annuitant must stay the same on both contracts, and the money must move directly from the old insurance company to the new one. Miss any of those, and the IRS treats the whole thing as a taxable surrender.
What Section 1035 Actually Covers
Section 1035 of the Internal Revenue Code says no gain or loss is recognized when you exchange one annuity for another annuity, or when you exchange an annuity for a qualified long-term care insurance contract.1Office of the Law Revision Counsel. 26 U.S. Code 1035 – Certain Exchanges of Insurance Policies The new contract is treated as a continuation of the old one. Any growth stays tax-deferred until you actually take distributions.
The permitted swaps run in only one direction. You can exchange a life insurance policy for an annuity, and you can exchange either a life policy or an annuity for a long-term care contract.1Office of the Law Revision Counsel. 26 U.S. Code 1035 – Certain Exchanges of Insurance Policies You cannot exchange an annuity for a life insurance policy. A swap outside these categories is treated as a taxable distribution.
Section 1035 Does Not Apply Inside an IRA or 401(k)
Section 1035 only covers non-qualified annuities, meaning annuities bought with after-tax money outside a retirement plan. If your annuity sits inside an IRA, 401(k), or 403(b), Section 1035 does not govern the move. Qualified accounts have their own rules for trustee-to-trustee transfers and 60-day rollovers, and confusing the two frameworks is one of the more expensive mistakes people make.
If you hold an annuity inside an IRA and want to switch carriers, the correct route is a direct trustee-to-trustee transfer under the IRA rules, not a 1035 exchange. The paperwork looks similar and the end result is the same, but the legal authority is different. Confirm which process applies before you sign.
The Two Requirements You Cannot Bend
The same person or persons must remain as owner and annuitant on both contracts. You cannot use a 1035 exchange to move an annuity into someone else’s name or to add a co-owner who wasn’t on the original contract.2Internal Revenue Service. Rev. Rul. 2003-76 – Part I Section 1035 Certain Exchanges of Insurance Policies Changing the ownership structure turns a tax-free exchange into a taxable distribution.
The funds must also travel directly between the two insurance companies. At no point should you have access to the cash surrender value.2Internal Revenue Service. Rev. Rul. 2003-76 – Part I Section 1035 Certain Exchanges of Insurance Policies If the old company cuts a check to you personally, the IRS treats you as having received a distribution. There is no 60-day rollover window for non-qualified annuities the way there is for IRAs. Once the money touches your hands, the tax-free treatment is gone.
The safest instruction to the surrendering carrier: any check must be payable to the new insurance company for your benefit, never to you.
Your Cost Basis Carries Over
Your original investment amount transfers to the new contract. Section 1035(d) cross-references the basis rules in Section 1031(d): the basis of what you receive equals the basis of what you gave up.1Office of the Law Revision Counsel. 26 U.S. Code 1035 – Certain Exchanges of Insurance Policies If you put $100,000 into an annuity that has grown to $150,000, your basis in the new contract is still $100,000. The $50,000 in gains stays deferred.
This carries forward to every future withdrawal. The new insurer needs the original basis to calculate the taxable portion of distributions years down the road. Get written confirmation of the transferred basis from the new carrier once the exchange settles. Errors here create tax problems long after the exchange is closed.
Partial Exchanges and the 180-Day Rule
You don’t have to transfer the entire annuity. Revenue Procedure 2011-38 allows a partial 1035 exchange, but with a firm timing restriction: you cannot take a distribution from either the original or the new contract during the 180 days after the transfer.3Internal Revenue Service. Rev. Proc. 2011-38
If you withdraw from either contract inside that 180-day window, the IRS may treat the partial exchange and the withdrawal as a single planned transaction. The withdrawn amount can be recharacterized as taxable boot alongside the exchange, or simply as a taxable distribution under the regular annuity rules.3Internal Revenue Service. Rev. Proc. 2011-38 The IRS has also indicated it will look at distributions within 24 months of a partial exchange for signs the exchange was designed to disguise a withdrawal.4Internal Revenue Service. Notice 2003-51 – Certain Exchanges of Insurance Policies
One helpful point: after a valid partial exchange, the IRS will not aggregate the two contracts for tax purposes, even if both end up at the same insurance company.3Internal Revenue Service. Rev. Proc. 2011-38 Each contract stands on its own going forward.
Outstanding Loans Become Taxable Boot
An outstanding loan against the old annuity complicates the tax picture. When the old contract is surrendered, any loan balance that isn’t repaid is generally treated as something you received in addition to the new contract. Under Section 1035(d), which points to the Section 1031 rules, money or other property received alongside the new contract is “boot” and is taxable to the extent of your gain.1Office of the Law Revision Counsel. 26 U.S. Code 1035 – Certain Exchanges of Insurance Policies The surrendering company will report the forgiven loan amount on a separate Form 1099-R.
The cleanest fix is to repay the loan before initiating the exchange. If that isn’t possible, at least run the numbers first. Your taxable gain is capped at the difference between the total contract value and your cost basis, so the taxable portion of loan forgiveness depends on how much growth the contract has accumulated.
How the Exchange Shows Up on a 1099-R
The surrendering insurance company files a Form 1099-R for the year of the exchange. For a fully tax-free 1035, Box 1 shows the total value transferred, Box 2a shows zero as the taxable amount, and Box 7 carries distribution code 6, which tells the IRS this was a Section 1035 exchange.5Internal Revenue Service. 2025 Instructions for Forms 1099-R and 5498 You owe no tax on that amount, but you still have to report it.
If any part of the exchange is taxable, such as forgiven loan balance or other boot, the company issues a separate 1099-R for the taxable portion.5Internal Revenue Service. 2025 Instructions for Forms 1099-R and 5498 Hold on to every 1099-R and your records of the original cost basis. The insurer uses the basis to calculate tax on future withdrawals, but if the number is wrong, the IRS holds you responsible.
What Happens When an Exchange Fails
A disqualified exchange, typically because you took possession of the funds or the contract ownership changed, is treated as a surrender of the old annuity followed by the purchase of a new one. The gain in the old contract becomes ordinary income in the year of the surrender.
If you’re under age 59½, it gets worse. Section 72(q) adds a 10% tax on the taxable portion of a premature distribution from an annuity. Narrow exceptions exist for distributions after death or disability, or as part of a series of substantially equal periodic payments, but a botched exchange almost never fits any of them.6Office of the Law Revision Counsel. 26 U.S. Code 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts On $50,000 of gains, that alone is $5,000 in penalty tax, layered on top of ordinary income tax on the full gain.
Two habits prevent almost every failed exchange: keep the owner and annuitant identical on the new contract, and never accept a check made payable to you. If the old company insists on cutting a check, it should go to the new insurer for your benefit. Everything else in a 1035 exchange is administrative. Those two facts are the tax rules.