Annuity 1035 Exchange: Rules, Steps and Pitfalls

An annuity 1035 exchange lets you move the money in an existing annuity into a new annuity contract without paying income tax on the gains at the time of the move. The tax-free result depends on doing it the way the Internal Revenue Code and the IRS require: a direct transfer between insurance companies, the same owner on both contracts, and no check made out to you along the way. This guide explains what qualifies, the rules that trip people up, the costs to check before you switch, and how the exchange shows up at tax time.

TL;DR

• Section 1035 of the tax code lets you swap an annuity for another annuity, or a life insurance policy for an annuity, without recognizing gain or loss on the swap.
• The money must move directly from one company to the other. If a check is made out to you and you endorse it to the new company, the IRS treats it as a taxable distribution.
• The same person or persons must be the obligee on the old and new annuity contract.
• Surrender charges, new fees and lost features can outweigh any benefit, so compare both contracts line by line before you sign.
• The exchange is generally reportable to the IRS on Form 1099-R, so keep your paperwork and tell your tax preparer.

Table of Contents

• What a 1035 exchange actually does
• Which exchanges qualify
• The rules that make or break the exchange
• What to compare before you exchange
• Step by step: how an exchange works
• Do you report a 1035 exchange on your tax return?
• Is a 1035 exchange a good idea?
• Our perspective
• Getting a second set of eyes on your contract
• Common mistakes to avoid
• FAQ
• Sources

What a 1035 exchange actually does

When you cash out an annuity, the earnings are taxed as income. A 1035 exchange avoids that tax bill by treating the move as a continuation of the same investment rather than a sale. The SEC's investor education site describes it this way: Section 1035 lets you exchange an existing variable annuity for a new annuity contract without paying tax on the income and investment gains in your current account.

The name comes from the section of the Internal Revenue Code that authorizes it. The legislative purpose, as the IRS has summarized it, is that tax-free treatment is appropriate when someone exchanges one insurance policy for another better suited to their needs. That phrase is worth holding on to. The tax code does not care whether the new contract is better for you. It only cares that the exchange follows the rules. Whether the new contract is actually better is the question you have to answer before you sign.

Two things a 1035 exchange does not do:

• It does not erase the tax. It defers it. The gains stay in the new contract and are generally taxed when money later comes out.
• It does not make a bad contract good. A tax-free move into a contract with higher costs is still a move into higher costs.

Which exchanges qualify

The statute, 26 U.S.C. § 1035, lists the swaps that can be made without recognizing gain or loss. The ones most readers ask about:

That last row matters. The statute allows life insurance to move into an annuity, but the annuity side of the law only lists another annuity or a qualified long-term care contract as the destination. If you are considering turning an annuity into life insurance, talk to a licensed professional and your tax advisor before moving anything.

Annuity to annuity

This is the most common version and the one most people searching this topic have in mind. You might want to move from an older contract with limited investment choices, from a contract with high ongoing charges, or from a company whose service you are unhappy with. Under § 1035(a)(3), an annuity contract may be exchanged for another annuity contract without recognizing gain or loss.

Life insurance to annuity

Some people hold a permanent life insurance policy that they no longer need, perhaps because the kids are grown or the mortgage is paid. Section 1035(a)(1) lets a life insurance contract be exchanged for an annuity contract without recognition of gain or loss. Before doing this, check whether anyone still depends on that death benefit. If your coverage question is open, our guide on life insurance steps for retirees walks through what to confirm before you cancel or change anything.

Annuity to long-term care coverage

The same subsection allows an annuity to be exchanged for a qualified long-term care insurance contract. This is a niche but real use for money that was set aside for retirement income and may be better directed at care costs.

The rules that make or break the exchange

Most failed exchanges fail on mechanics, not on eligibility. These are the rules to know.

1. Move the money directly between companies

The IRS has been clear on this. If you receive a check from a nonqualified annuity and endorse it to a second company, the IRS treats that as a taxable distribution under § 72(e), not a tax-free exchange. The correct process has the new insurance company request the transfer from the old one, and the funds travel company to company. Your role is to sign the paperwork, not to touch the money.

2. Keep the same owner on both contracts

The Treasury regulation requires that for an annuity-to-annuity exchange under § 1035(a)(3), the same person or persons must be the obligee under both the original and the new contract. In plain terms: if the old annuity is in your name alone, the new one should be in your name alone. Adding a spouse, changing owners or retitling the contract as part of the switch can put the tax-free treatment at risk.

3. Watch partial exchanges and the 180-day window

You do not have to move the whole contract. The Tax Court in Conway v. Commissioner held that a direct transfer of part of an annuity to an unrelated company for a new contract is a tax-free exchange under § 1035. The IRS then set out a procedure for partial exchanges. Under it, no amount other than qualifying annuity payments may be received under either contract during the 180 days beginning on the transfer date. In practice, that means taking a withdrawal from either the old or the new contract shortly after a partial exchange can undo the treatment, so plan your cash needs before you split a contract.

4. Know the foreign-person limit

To the extent provided in regulations, § 1035(a) does not apply to an exchange that has the effect of transferring property to a person other than a U.S. person. This rarely affects domestic households, but anyone with international ties should raise it with a tax professional.

5. Qualified money follows different rules

An annuity held inside an IRA or employer plan is already tax-deferred by the account, and moving it is usually done through a trustee-to-trustee transfer or rollover rather than a § 1035 exchange. If you are looking at rolling a workplace plan into an annuity, that is a separate process with its own paperwork. Ask before assuming that the nonqualified rules apply.

What to compare before you exchange

Qualifying for a tax-free exchange is the easy part. The harder part is deciding whether to do it. FINRA's guidance on variable annuity exchanges tells investors to weigh surrender charges on the old policy, higher charges or fees in the new contract, and whether they actually need the new contract's features. It also notes that bonus credits may be offset by higher expenses, and that you should exchange only if the new contract better positions you to reach your financial goals.

Here is a practical checklist to put the two contracts side by side.

1. Surrender charges on the old contract. Surrender charges may be owed if you withdraw money before a specified period expires. Ask the current company for the exact schedule and what the charge would be today, in dollars. Our guide to annuity surrender rules explains how these schedules typically work.
2. A new surrender period. A new contract usually starts its own surrender schedule. Find out how long it runs and how it steps down.
3. Annual costs. Compare mortality and expense charges, administrative fees, fund expenses and rider fees on both contracts. Ask for them in writing.
4. Benefits you would give up. Check the old contract for guaranteed income features, death benefit terms or guaranteed interest rates that may not exist in a new contract.
5. Benefits you actually need. A feature you will never use is not a reason to pay for it.
6. Your timeline. If you plan to take income soon, a long new surrender period may not suit you.
7. The company behind the promise. Annuity guarantees rest on the claims-paying ability of the insurer, so look at the financial strength of both companies.

A simple worked example

Suppose you own a deferred annuity with a current value of $150,000 and a cost basis (what you originally paid in) of $100,000. A cash surrender would leave $50,000 of gain subject to income tax, plus any surrender charge. A direct 1035 exchange moves the $150,000 into the new contract with no tax on the gain at the time of the move. These figures are an illustration only, not a quote or a prediction. If the old contract still has a surrender charge of, say, a few percent, that cost is real money, and you would need the new contract to be meaningfully better to justify paying it.

Step by step: how an exchange works

1. Gather the old contract details. Get the contract number, current value, surrender schedule, any riders and the cost basis from your current company.
2. Compare options. Look at the new contract's costs, features and the insurer's strength, using the checklist above.
3. Complete the new company's application and exchange form. Many carriers have a dedicated 1035 exchange or transfer request form. Make sure the owner name and details match the old contract.
4. Let the companies handle the transfer. The new company sends the request to the old one, and the funds move directly. Do not accept a check in your name.
5. Confirm completion. Get written confirmation of the amount received, the new contract's value and the basis carried over.
6. Keep your records. You will want the transfer paperwork and tax forms when you file and when you later take withdrawals.

Do you report a 1035 exchange on your tax return?

A tax-free exchange is still something the insurance companies report. The IRS instructions for Forms 1099-R state that these exchanges of contracts are generally reportable on Form 1099-R, with some limited exceptions. The same instructions note that if you receive other property or a loan is canceled at the time of the exchange, that portion may be taxable and reported separately.

What that means for you: expect a 1099-R from the old company even if you owe no tax on the exchange, and give it to your tax preparer along with the transfer confirmation so the exchange is entered as non-taxable rather than as a withdrawal. If the form looks wrong, contact the issuing company before you file.

Is a 1035 exchange a good idea?

Sometimes. It makes sense when the new contract has clearly lower costs, a feature you need, or a better insurer, and when the savings outweigh surrender charges and any new surrender period. It makes less sense when the main driver is a sales pitch about a bonus, a higher advertised rate or a feature you cannot explain in your own words.

Two questions cut through most of the noise: What do I gain, in dollars or in guaranteed features I will use? And what do I give up, including surrender charges, benefits and time? If the person recommending the exchange cannot answer both in writing, wait.

Our perspective

Most people who call us about an annuity exchange have already been told the tax part is easy, and it is. The part nobody explains is everything around it: the surrender schedule on the old contract, the new schedule that starts the day you sign, and the riders that quietly cost a percentage point or more a year.

We are licensed with multiple carriers, so we can lay out options side by side instead of steering you toward one company's product. Our advice costs you nothing, and we would rather tell you to keep what you have than help you with a switch that does not pay off. When an exchange does make sense, we make sure the money moves directly between companies and the ownership matches, so the tax treatment is protected.

And because life changes, we stay in touch after the paperwork is done. Retirement, a move, a new diagnosis or a change in income can all change what the right contract looks like.

Brian

Getting a second set of eyes on your contract

If you are weighing an annuity exchange, or deciding what to do with an old life insurance policy, we can review your current contract, explain the charges in plain language and compare it with alternatives from the carriers we work with. Our advisors serve Michigan residents and clients nationwide, and our guidance is provided at no cost to you. You can see the full list of what we help with on our services page.

If you are also approaching 65, we can coordinate your retirement income decisions with your Medicare options, so one choice does not undercut another.

Have questions? We have answers! Contact us to schedule a no-obligation meeting.

• Contact: pbabiz.com/contact
• Call or text: 616-221-4616
• Meet on your terms: In Person • Phone • Virtual

Common mistakes to avoid

• Taking the check yourself. Even with good intentions, a check made out to you and endorsed to the new company is treated as a distribution.
• Changing the owner during the exchange. Keep the obligee the same on both contracts.
• Withdrawing too soon after a partial exchange. The 180-day window for partial exchanges is easy to forget.
• Ignoring the old contract's guarantees. Once the exchange is done, it generally cannot be reversed on your terms.
• Cancelling a life insurance policy before the exchange is complete. Let the transfer finish and the new contract be issued before you close anything out.
• Not telling your tax preparer. A 1099-R for a tax-free exchange can look like a taxable event if no one explains it.

FAQ

Can I exchange one annuity for another without paying tax?

Yes. Section 1035(a)(3) of the tax code allows an annuity contract to be exchanged for another annuity contract without recognition of gain or loss. The exchange has to be a direct transfer between companies, and the same person or persons must be the owner of both contracts. Surrender charges and new fees can still apply even when there is no tax.

Can I move a life insurance policy into an annuity?

Yes. Under § 1035(a)(1), a life insurance contract can be exchanged for an annuity contract without recognizing gain or loss. Before you do, confirm that no one still relies on the death benefit, and check for surrender charges or policy loans on the life insurance policy.

What happens if I get a check and send it to the new company?

The IRS treats a check from a nonqualified annuity that you endorse to a second company as a taxable distribution, not a 1035 exchange. To keep the tax-free treatment, the new company should request the funds directly from the old one. If a check was already issued in your name, call the new company and a tax professional before depositing or forwarding it.

Can I exchange only part of an annuity?

Yes, a direct partial transfer to an unrelated company can qualify. For the IRS partial-exchange procedure, no amount other than qualifying annuity payments may be received under either contract during the 180 days beginning on the transfer date. Ask your advisor and tax preparer to map out that window before you split a contract.

Do I have to report a 1035 exchange?

The insurance companies generally report these exchanges to the IRS on Form 1099-R, even when no tax is due. Give the form and your transfer confirmation to your tax preparer so the exchange is not entered as a taxable withdrawal.

Sources

• Section 1035 | Investor.gov
• Should You Exchange Your Variable Annuity? | FINRA
• 26 U.S.C. § 1035: Certain exchanges of insurance policies
• 26 U.S. Code § 1035 | Cornell Law School
• 26 CFR § 1.1035-1
• IRS Notice 2011-68
• IRS Revenue Procedure 2011-38
• Instructions for Forms 1099-R and 5498 | IRS

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• U.S. Annuities: Check Surrender Rules Before Choosing a Payout
• MYGA Annuity: How It Works, Risks and CD Comparison