You have $180,000 sitting in an annuity purchased a decade ago, earning 2.1% while newer contracts are paying 5.50% or more. Moving that money without triggering a massive tax bill sounds complicated – but a 1035 exchange makes it possible. This guide walks through exactly how the process works, what the IRS requires, and the mistakes that cost people thousands.
What Is a 1035 Exchange?
A 1035 exchange is a tax-free transfer that lets you move money from one annuity contract to another – or from a life insurance policy to an annuity – without paying income taxes on any accumulated gains at the time of transfer. The name comes from Section 1035 of the Internal Revenue Code, which authorizes these transfers.
Without this rule, moving money from an old annuity to a new one would be treated as a taxable withdrawal. Every dollar of growth above your original investment (your “cost basis”) would be taxed as ordinary income in the year you made the switch.
Consider Robert, age 67. He invested $120,000 in a variable annuity in 2009. The account has grown to $195,000, giving him $75,000 in gains. If he surrendered the old contract and deposited the cash into a new annuity, he would owe income tax on all $75,000 – potentially $16,500 to $24,750 at a 22%-33% rate. A 1035 exchange eliminates that immediate tax hit.
What Qualifies for a 1035 Exchange?
The IRS allows 1035 exchanges between specific types of contracts. Not every financial product qualifies, so the starting point is knowing which combinations are permitted.
Permitted 1035 Exchange Combinations
| From (Old Contract) | To (New Contract) | Tax-Free? |
|---|---|---|
| Life insurance policy | Life insurance policy | Yes |
| Life insurance policy | Annuity contract | Yes |
| Life insurance policy | Long-term care insurance | Yes |
| Annuity contract | Annuity contract | Yes |
| Annuity contract | Life insurance policy | No – not permitted |
| Endowment policy | Annuity contract | Yes |
The most common scenario for people in the 55-70 age range is an annuity-to-annuity exchange. This might mean moving from a low-rate fixed annuity purchased years ago to a higher-rate MYGA, or switching from a variable annuity with high fees to a fixed index annuity with a lower cost structure.
Who Must Be the Same
The annuity owner and the annuitant must remain the same on both contracts. You cannot transfer your annuity into a contract owned by your spouse or child as part of a 1035 exchange. The IRS treats any change in ownership as a taxable distribution.
What Are the 1035 Exchange Rules?
A valid 1035 exchange requires direct carrier-to-carrier transfer. The new insurance company must receive the funds directly from the old insurance company – you cannot take a check made out to yourself and deposit it into the new annuity.
Beyond the direct transfer requirement, here are the IRS rules that govern the exchange:
- Same owner, same annuitant: Both contracts must name the same individual as owner and annuitant.
- No constructive receipt: You cannot take possession of the funds at any point. The moment a check is made payable to you, the IRS considers it a distribution.
- Cost basis transfers: Your original investment (cost basis) carries over to the new contract. You do not get a “reset” on the tax treatment of your gains.
- Partial exchanges are allowed: You can exchange a portion of one annuity into a new contract. However, the IRS has added restrictions on taking withdrawals within 180 days of a partial exchange – more on that below.
- Qualified annuities have different rules: If your annuity is held inside an IRA or 401(k), a 1035 exchange does not apply. IRA-to-IRA rollovers follow a separate set of rules under the tax code.
Understanding the full tax picture around annuity transfers is covered in detail in our guide on how annuities are taxed.
How to Do a 1035 Exchange: Step-by-Step
A 1035 exchange is handled almost entirely through paperwork between the two insurance companies. Your job is to initiate it and make sure the right forms are completed correctly.
Step 1: Choose Your New Annuity
Before filling out a single form, select the new annuity product you want to move into. Compare rates, surrender charge schedules, carrier financial strength ratings, and contract features. If you are moving into a multi-year guaranteed annuity (MYGA), confirm the guaranteed rate period and any early withdrawal penalties.
Do not sign any paperwork for the new contract until you are certain of your decision. Once the exchange is initiated, unwinding it can trigger surrender charges on the original contract.
Step 2: Gather Your Current Contract Information
Locate your existing annuity contract and note the following:
- Contract number and insurance company name
- Current account value
- Your cost basis (the total amount you deposited, after any prior withdrawals)
- Surrender charge schedule and whether any charges currently apply
- Any outstanding loans against the contract
Your current carrier can provide a “surrender value” illustration that shows exactly what you would receive after any applicable charges. Request this before proceeding.
Step 3: Complete the 1035 Exchange Forms at the Receiving Company
The new insurance company – the one receiving the funds – will provide a 1035 exchange request form. This form typically asks for:
- Your personal information (name, address, Social Security number)
- The name and address of the surrendering carrier
- Your existing contract number
- Whether you want a full or partial exchange
- How the funds should be invested in the new contract
Sign the form exactly as your name appears on the existing contract. Any discrepancy can delay or invalidate the transfer.
Step 4: The Receiving Company Contacts Your Old Carrier
After you submit the completed forms, the new insurance company sends a transfer request to your existing carrier. Your old carrier will then process the surrender of your account and send the funds directly to the new carrier. You will not receive a check.
This process typically takes 2-6 weeks, depending on the carriers involved. Some companies are faster than others. Ask both carriers for a timeline estimate before you start.
Step 5: Verify the Transfer and Your New Contract
Once the transfer is complete, the new carrier will issue your annuity contract. Review it carefully to confirm:
- The contract value matches what you expected
- The guaranteed rate (if applicable) matches what you were quoted
- Your cost basis was transferred correctly
- Your name and ownership information are accurate
Keep copies of all paperwork, including the original 1035 exchange request and the confirmation from both carriers. This documentation is your proof that the transfer was tax-free if the IRS ever has questions.
Step 6: Report the Exchange on Your Tax Return
Your old carrier will send you a Form 1099-R showing the distribution. However, because this was a 1035 exchange, no taxes are due. The 1099-R should show a distribution code of “6” in Box 7, indicating a 1035 exchange. Report this on your federal tax return (Form 1040) but note it as a non-taxable rollover.
What to Watch Out For Before You Exchange
A 1035 exchange eliminates the immediate tax bill, but it does not eliminate every cost. Several factors can reduce – or eliminate – the financial benefit of switching contracts.
Surrender Charges on the Old Contract
If your existing annuity is still within its surrender charge period, exchanging it will trigger those charges. Annuity surrender charges typically range from 5% to 10% of the contract value in early years, declining to zero over a 7 to 10-year period.
Sandra, age 63, bought a fixed index annuity in 2022 with a 10-year surrender schedule. In 2026, she is still in year 4, where the surrender charge is 8%. On a $200,000 contract, exchanging now would cost $16,000. That charge would wipe out multiple years of higher earnings from the new contract.
Before initiating any exchange, calculate the break-even point: how many years at the higher rate in the new contract would it take to recover the surrender charge?
Surrender Charges on the New Contract
The new annuity will typically have its own surrender charge schedule, restarting the clock. If you may need to access the funds within 3-7 years, confirm that the new contract’s free withdrawal provisions and surrender schedule align with your timeline.
Loss of Existing Benefits and Riders
Some older annuity contracts include guaranteed minimum income benefits, living benefits, or death benefit riders that cannot be replicated in a new contract. If your current annuity has a guaranteed income rider with a high benefit base, exchanging to a new contract means permanently giving up that guarantee.
This tradeoff must be evaluated carefully. A 1% higher rate in a new contract may not be worth surrendering a guaranteed 6% income rider rollup on a $200,000 benefit base.
Tax Deferral Timing
Your gains are not eliminated by a 1035 exchange – they are deferred. The cost basis from your old contract carries into the new one, and you will owe taxes on those accumulated gains when you eventually take distributions. Understanding how tax-deferred growth works in annuities helps you plan your withdrawal strategy around the new contract.
1035 Exchange vs. Surrendering an Annuity: Which Costs Less?
Surrendering an annuity and depositing the proceeds into a new one will almost always cost more than a 1035 exchange, due to the immediate tax liability on gains.
Here is a side-by-side comparison using a concrete example. Patricia, age 65, has a non-qualified annuity worth $250,000 with a cost basis of $150,000 (meaning $100,000 in accumulated gains). She is in the 24% federal tax bracket and her state charges 5% income tax.
| Factor | 1035 Exchange | Surrender + Reinvest |
|---|---|---|
| Contract value transferred | $250,000 | $250,000 |
| Taxable gain recognized | $0 | $100,000 |
| Federal income tax (24%) | $0 | $24,000 |
| State income tax (5%) | $0 | $5,000 |
| Amount invested in new contract | $250,000 | $221,000 |
| Immediate cost | $0 (plus any surrender charge) | $29,000 |
On a $250,000 contract with $100,000 in gains, Patricia would need to come out $29,000 ahead in the new contract just to break even against a standard surrender. For most people making this switch, a 1035 exchange is clearly the better path.
Common 1035 Exchange Mistakes
These are the errors that most often derail exchanges or trigger unexpected tax bills.
Taking a Check Payable to Yourself
If your old carrier issues a check made payable to you – even if you immediately deposit it into the new annuity – the IRS treats it as a taxable distribution. The transfer must go directly from carrier to carrier. Always make sure the paperwork specifies a direct 1035 exchange, not a check payable to the owner.
Ignoring the 180-Day Partial Exchange Rule
If you do a partial 1035 exchange (moving a portion of one annuity into a new contract), the IRS will treat any withdrawal from either contract within 180 days as a taxable distribution – not part of the exchange. This catches people off guard when they need a small amount of cash shortly after completing a partial transfer.
Not Confirming Cost Basis Transfer
When the transfer is complete, verify that the new carrier has your correct cost basis on file. If the cost basis is not documented properly, you may be taxed on more income than you actually owe when you start taking distributions years later. Request written confirmation from the new carrier that your cost basis has been recorded.
Exchanging a Qualified Annuity Using 1035 Rules
Annuities held inside IRAs or employer retirement plans are already tax-deferred under qualified account rules. Moving them follows IRA rollover rules (not 1035 exchange rules). Using the wrong paperwork or process for a qualified annuity can create tax problems. If your annuity is inside an IRA, talk with a tax advisor before initiating any transfer.
Failing to Compare Total Contract Costs
A higher credited rate in a new contract does not automatically mean you come out ahead. Factor in surrender charges on both contracts, any rider fees in the new contract, and the overall fee structure. Use the carrier review section to compare financial strength ratings and contract terms across top annuity companies before committing to the new contract.
Frequently Asked Questions
Does a 1035 exchange reset my surrender charge period?
Yes. When you exchange into a new annuity contract, the new contract’s surrender charge schedule starts from the date of the exchange, not from the original purchase date of your old contract. If the new annuity has a 7-year surrender period, you are starting that clock over from day one.
How long does a 1035 exchange take?
Most 1035 exchanges are completed within 2 to 6 weeks. The timeline depends on how quickly both carriers process the paperwork and transfer the funds. Some carriers are known for faster processing than others. Ask both companies for a typical processing time before you begin.
Can I do a partial 1035 exchange?
Yes, the IRS allows partial 1035 exchanges – you can move a portion of one annuity into a new contract while keeping the rest in the original. However, taking any withdrawal from either contract within 180 days of the partial exchange will cause the IRS to treat that withdrawal as ordinary income rather than part of the tax-free exchange. Plan your cash flow needs carefully before doing a partial exchange.
Can I do a 1035 exchange from a variable annuity to a fixed annuity?
Yes. Any annuity-to-annuity exchange qualifies under Section 1035, regardless of annuity type – variable to fixed, fixed to indexed, indexed to MYGA, or any other combination. The requirement is that both contracts are annuity products, the owner and annuitant remain the same, and the transfer is direct carrier-to-carrier.
Related Reading
- How Are Annuities Taxed? The Complete 2026 Guide – Understand the full tax treatment of annuity contributions, growth, and distributions before and after an exchange.
- Tax-Deferred Growth in Annuities Explained – How compounding works inside a tax-deferred contract and why it matters for your exchange decision.
- Annuity Surrender Charges Explained – What surrender charges are, how to read the schedule, and how to calculate whether an exchange makes financial sense.
- What Is a MYGA? Multi-Year Guaranteed Annuity Guide – If you are exchanging into a MYGA, this guide covers rates, terms, and what to compare across carriers.
- Annuity Carrier Reviews – Compare financial strength ratings, product lineups, and contract terms for the top annuity companies in 2026.
Sources & Citations
- IRS Publication 575: Pension and Annuity Income – The IRS’s official guidance on reporting annuity income, cost basis, and the tax treatment of 1035 exchanges.
- IRS Internal Revenue Code Section 1035 – Exchange of Annuity Contracts – The authoritative statutory source for the 1035 exchange rules and permitted contract combinations.
- FINRA: Annuities – Investor Insights – FINRA’s consumer guidance on annuity features, fees, and what investors should evaluate before switching contracts.
- NAIC Consumer Alert: 1035 Exchanges – The National Association of Insurance Commissioners’ guidance for consumers on evaluating whether a 1035 exchange is appropriate.
- IRS Form 1099-R: Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans – How to read the 1099-R you receive after completing a 1035 exchange, including the Distribution Code 6 designation.
