1035 Exchange Annuity: What Annuity Owners Need to Know
- Jib Hunt
- Aug 9
- 15 min read
Yes, you can move a non-qualified annuity into another annuity completely tax-free — but only if the transfer is a direct, carrier-to-carrier exchange that satisfies Section 1035 of the Internal Revenue Code. Your cost basis carries over into the new contract, taxes stay deferred, and no gain is recognized at the time of transfer. That is the core promise of a 1035 exchange.
Three things can unravel it quickly:
Direct transfer required. Funds must travel from the old carrier to the new carrier. If you receive a check and endorse it, the IRS treats the transaction as a taxable distribution.
Owner and annuitant must stay the same. Changing either party at the time of the exchange typically triggers a taxable event.
Loans can create taxable “boot.” An outstanding policy loan that the old carrier discharges — rather than the new carrier assuming — may be treated as taxable income.
Before you sign anything, pull your current surrender schedule, check whether any loan is outstanding, confirm the new carrier will assume that loan if one exists, and run a net-of-fees comparison. The tax benefit is real, but it can be eaten by surrender charges, restarted surrender periods, and higher ongoing fees on the new contract.
Key Takeaways
A properly executed 1035 exchange transfers your annuity’s cost basis intact to the new contract, defers all gain, and generates no taxable income — provided the transfer is direct, the owner and annuitant remain the same, and no cash is received.
Point | Details |
Direct transfer is non-negotiable | Funds must go carrier-to-carrier; receiving a check converts the exchange into a taxable distribution. |
Basis carries over intact | Your after-tax cost basis transfers to the new contract and continues to reduce future taxable withdrawals. |
180-day rule governs partial exchanges | Neither contract may pay out any amount within 180 days of a partial transfer without risking IRS recharacterization. |
Costs can outweigh the tax benefit | Surrender charges, restarted surrender periods, and higher fees must be modeled against the tax savings before proceeding. |
East Two West coordinates the comparison | East Two West provides multi-carrier quotes and handles transfer paperwork; consult a CPA for the tax consequences specific to your contract. |
Use the worked examples and the advisor questions list in this article as your starting point for any consultation.
Table of Contents
What does Section 1035 actually cover?
26 U.S.C. § 1035 is a narrow but powerful provision. It says no gain or loss is recognized when you exchange one annuity contract for another annuity contract, provided the obligee (the person whose life the contract is based on) remains the same. The statute also permits exchanges from a life insurance policy into an annuity, and from one life insurance policy into another. The one-way street: an annuity cannot be exchanged into a life insurance policy. The logic is straightforward — an annuity is a less favorable tax vehicle than life insurance, so Congress allows upgrades but not downgrades.
The statutory rule: “No gain or loss shall be recognized on the exchange of a contract of life insurance for another contract of life insurance or for an endowment or annuity contract or for a qualified long-term care insurance contract… or of an annuity contract for an annuity contract or for a qualified long-term care insurance contract.” — 26 U.S.C. § 1035(a)
Treasury and IRS guidance — through revenue rulings, revenue procedures, and notices — fills in the practical details the statute leaves open. Rev. Proc. 2008-24 introduced interim guidance on partial exchanges. Rev. Proc. 2011-38 later refined those rules and established the 180-day timing test still in use today. Together, these documents define when a partial transfer qualifies as tax-free and how basis is split between the original and new contracts.
How a 1035 exchange actually works
The mechanics are simpler than the tax code makes them sound, but the details matter.
Direct carrier-to-carrier transfer. The old carrier sends the funds directly to the new carrier. You, the owner, never touch the money. Investopedia confirms that the owner cannot receive a check at any point in the process — doing so converts the transaction into a taxable distribution.
Owner and annuitant identity. The owner and annuitant on the new contract must be the same as on the old contract. Adding a joint owner or swapping the annuitant at the time of transfer can disqualify the exchange.
Basis carryover. Your investment in the contract — your after-tax cost basis — transfers intact to the new annuity. If you put $80,000 into an annuity now worth $120,000, that $80,000 basis follows the contract. Future withdrawals from the new annuity are taxed on the same gain-first (LIFO) basis as the original.
IRS ruling framework. The carrier-to-carrier mechanics and identity requirements are grounded in IRS revenue rulings going back decades. Rev. Rul. 2007-24 is the canonical authority on what breaks the exchange; the revenue procedures cited above govern partial transfers.
One practical note: the new contract is often not issued until the funds actually arrive from the old carrier. That gap — sometimes two to four weeks — means you may briefly have no annuity coverage in force. Confirm with both carriers how they handle interim coverage before initiating the transfer.
What §1035 allows and what it does not
Permitted exchanges
Annuity contract to another annuity contract (the most common scenario)
Life insurance policy to another life insurance policy
Life insurance policy to an annuity contract
Either of the above to a qualified long-term care insurance contract
Prohibited actions that void tax-free treatment
Receiving a check. Rev. Rul. 2007-24 is explicit: if you receive a check from the original issuer and endorse it to a second issuer, the IRS treats the full transaction as a taxable distribution under §72(e). The endorsement-to-second-company scenario is the single most common way owners accidentally trigger a tax bill.
Changing the owner or annuitant at transfer. If you change the annuitant from yourself to your spouse as part of the exchange, the IRS can treat the transfer as a taxable event. Make any ownership changes before or well after the exchange, not simultaneously.
Annuity to life insurance. The statute does not permit this direction of exchange. An annuity owner who wants life insurance must purchase a new policy separately.
Receiving taxable boot. If the old carrier discharges a policy loan rather than transferring it, the forgiven loan amount is boot — taxable to the extent of gain in the contract, reported on Form 1099-R.
Example of the endorsement trap: You call your old carrier, request a surrender check for $150,000, and plan to deposit it into a new annuity the same week. Even if you complete the new application the next day, the IRS sees a taxable distribution of $150,000 (less your basis) the moment you received that check. The 1035 treatment is gone.
Partial exchanges and the 180-day timing rule
A partial exchange lets you move a portion of one annuity’s cash value into a new annuity while keeping the original contract in force. The IRS permits this, but the rules are tighter.
Rev. Proc. 2011-38 established the current standard: if either the original or the new contract pays out any amount within 180 days of the partial transfer, the IRS may recharacterize the entire transfer as a taxable distribution based on facts and circumstances. The 180-day clock runs from the date the partial transfer is completed. Rev. Proc. 2008-24 was the predecessor guidance that introduced an earlier version of this timing test; the 2011 procedure shortened and clarified it.
How basis is allocated in a partial exchange:
Basis is split between the two contracts in proportion to the cash value transferred. Per IRS Rev. Rul. 2003-76, the allocation is pro rata based on the percentage of total cash surrender value moved to the new contract.
Example: Your annuity has a cash value of $100,000 and a cost basis of $60,000. You transfer 40% of the cash value ($40,000) to a new annuity. Your basis in the new contract is 40% of $60,000 = $24,000. The remaining basis in the original contract is $36,000.
180-day rule in practice: Do not take any withdrawals, surrenders, or annuity payments from either contract for at least 180 days after completing a partial transfer. A single distribution within that window gives the IRS grounds to treat the partial exchange as taxable.
If the 180-day test is not met, the Service evaluates the facts and circumstances to determine whether the transfer was a genuine exchange or a disguised distribution. In practice, that analysis rarely favors the taxpayer.
All the costs and trade-offs to compare before exchanging
The tax benefit of a 1035 exchange is real, but it does not exist in a vacuum. FINRA warns that exchanges are not always beneficial and that surrender charges, restarted surrender periods, and lost contract benefits can easily outweigh the advantages of moving to a new product.
Costs to check on the old contract
Surrender charges. Most deferred annuities carry surrender charge schedules of 5–10 years. Surrendering in year three of a seven-year schedule can cost 6%–8% of contract value.
Market value adjustments (MVA). Fixed indexed and fixed annuities often include an MVA that can increase or decrease the surrender value depending on interest rate movements.
Loss of grandfathered benefits. Older contracts sometimes carry guaranteed minimum income benefits (GMIBs), guaranteed minimum withdrawal benefits (GMWBs), or favorable mortality tables that disappear when you exchange.
Costs introduced by the new contract
Restarted surrender period. Moving to a new annuity typically starts a brand-new 5–10 year surrender schedule. If you need liquidity within that window, you will pay to access your own money.
Higher mortality and expense (M&E) fees. Variable annuities in particular carry M&E charges that vary widely. A new contract may have higher ongoing fees than your current one.
Rider fees. Income riders, enhanced death benefit riders, and long-term care riders add annual charges, often 0.5%–1.5% of contract value per rider.
Bonus credits and the offset problem. Investor that bonus or premium credits on new annuities commonly range from 1%–5%, but these bonuses are frequently offset by higher annual expenses or longer surrender periods. A 5% bonus that costs you an extra 0.75% per year in fees takes roughly seven years just to break even on the fee difference alone.
Pro Tip: Build a simple break-even model before you sign. Take the net surrender value after charges on the old contract, add the bonus credit on the new contract, then subtract the incremental annual fee difference. Divide the net cost by the annual fee savings (or add the annual fee increase). That quotient is your break-even year. If it exceeds your time horizon, the exchange likely does not improve your position.
When does a 1035 exchange make sense?
Not every annuity owner should execute a 1035 exchange. The decision comes down to whether the new contract genuinely improves your long-term outcome after all costs are accounted for.
Decision checklist
[ ] Your current annuity has passed its surrender charge period (or charges are minimal relative to the benefit gained).
[ ] The new contract offers materially better terms: lower fees, stronger guarantees, or a more suitable payout structure.
[ ] You have confirmed that any outstanding loan will be assumed by the new carrier, not discharged by the old one.
[ ] Your time horizon is long enough to recoup any costs introduced by the new contract’s surrender schedule.
[ ] You do not need liquidity within the new contract’s surrender period.
[ ] You have compared SPIA and MYGA options if your primary goal is guaranteed income — sometimes a different annuity structure serves you better than exchanging like-for-like.
[ ] You have confirmed the exchange does not involve qualified (IRA/401(k)) funds. A 1035 exchange applies to non-qualified annuities; qualified annuity transfers follow different rules.
Questions to take to your CPA and financial advisor
What is my current cost basis in the original contract, and how will it carry over?
Will the exchange trigger any state income tax consequences in addition to federal treatment?
Does my current contract have any grandfathered benefits — GMIBs, favorable annuity rates, or old-law tax treatment — that I would lose permanently?
If I have an outstanding loan, will the new carrier assume it, and what documentation do I need?
What is the realistic break-even point on the new contract’s fees versus the old contract’s fees?
Are there any pending changes to my financial situation — a large withdrawal need, a beneficiary change, a divorce — that should happen before or after the exchange?
Red flags that should stop an exchange
The new contract’s bonus disappears after fees within your expected holding period.
The new surrender period extends well beyond your likely need for liquidity.
The exchange is being recommended primarily because of the bonus credit, not because of a genuine improvement in contract terms.
You are in or near the distribution phase and the new contract restarts a long surrender schedule.
Step-by-step: how to execute an annuity 1035 exchange
Most carrier-to-carrier exchanges complete in three to four weeks, though carriers may legally take longer. Here is the standard workflow:
Gather contract information. Obtain your current contract’s cash surrender value, surrender charge schedule, outstanding loan balance (if any), and cost basis from your current carrier.
Select the new annuity. Compare contracts across carriers. Confirm the new carrier will accept a 1035 exchange and, if applicable, will assume any outstanding loan.
Complete the new application. Fill out the new carrier’s annuity application. Designate the funding source as a 1035 exchange — this is a specific field on most applications.
Sign the absolute assignment / 1035 exchange form. This form instructs the old carrier to transfer funds directly to the new carrier. Both you (as owner) and the new carrier (as assignee) typically sign. Your agent or the new carrier usually provides this form.
New carrier submits the request. The new carrier sends the completed assignment form and application to the old carrier. You should not contact the old carrier independently to request a surrender — that risks triggering a check issuance.
Old carrier processes the transfer. The old carrier verifies the request, calculates the net transfer amount (cash surrender value minus any surrender charges), and wires or sends a check payable to the new carrier.
New carrier issues the contract. Once funds arrive, the new carrier applies them to your new annuity and issues the contract. Confirm the cost basis on the new contract matches your transferred basis.
Retain all documentation. Keep the assignment form, both carriers’ confirmation letters, and the new contract’s issued basis statement.
Tax reporting and post-exchange consequences
A clean 1035 exchange — no boot, no loan discharge, no check received — generates no taxable income and typically no Form 1099-R. The old carrier may issue a Form 1099-R with distribution code “6” to indicate a tax-free 1035 exchange, but no tax is owed.
When a Form 1099-R will be issued with taxable amounts
Boot received. If you receive any cash in addition to the new annuity contract, the boot is taxable to the extent of gain in the original contract.
Loan discharge. Per IRS Form 1099-R instructions, if the old carrier discharges an outstanding loan rather than the new carrier assuming it, the forgiven loan amount is treated as a taxable distribution. The taxable amount is limited to the gain in the contract.
Partial exchange followed by a distribution within 180 days. If either contract pays out within the 180-day window, the IRS may recharacterize the transfer, and a corrected 1099-R could follow.
How basis and gain work in the new contract
Your basis carries over exactly. Future withdrawals from the new annuity are taxed under the same LIFO (last-in, first-out) rules as any non-qualified annuity: gain comes out first as ordinary income, then basis comes out tax-free. The exchange does not reset the gain clock or give you a stepped-up basis.
Pro Tip: Keep a permanent file with: the original contract’s cost basis statement, the absolute assignment form, both carriers’ exchange confirmation letters, and the new contract’s issued basis confirmation. If the IRS ever questions the exchange years later, this paper trail is your defense. Loop in your CPA the year the exchange occurs so the 1099-R (code 6) is reported correctly on your return.
Worked examples: full and partial exchanges
Example 1: Full exchange with basis carryover
You own a non-qualified deferred annuity with a cash surrender value of $150,000 and a cost basis of $90,000. The gain in the contract is $60,000. You execute a full 1035 exchange into a new annuity.
Transfer amount: $150,000 (assuming no surrender charges)
Basis in new contract: $90,000 (carried over intact)
Gain in new contract: $60,000
Tax owed at exchange: $0
Later withdrawal of $20,000: The first $60,000 of withdrawals from a non-qualified annuity are gain (ordinary income). So this $20,000 withdrawal is fully taxable as ordinary income.
After $60,000 of withdrawals: Subsequent withdrawals return your $90,000 basis tax-free.
Item | Amount |
Cash surrender value transferred | $150,000 |
Cost basis carried to new contract | $90,000 |
Gain deferred (not taxed at exchange) | $60,000 |
Tax at time of exchange | $0 |
First $60,000 withdrawn later | Ordinary income |
Next $90,000 withdrawn later | Tax-free (return of basis) |
Example 2: Partial exchange with pro rata basis allocation
Same contract: $150,000 cash value, $90,000 basis. You transfer 40% of the cash value ($60,000) to a new annuity via a partial 1035 exchange.
Percentage transferred: $60,000 / $150,000 = 40%
Basis allocated to new contract: 40% × $90,000 = $36,000
Basis remaining in original contract: 60% × $90,000 = $54,000
Gain in new contract: $60,000 − $36,000 = $24,000
Gain remaining in original contract: $90,000 − $54,000 = $36,000
180-day rule: Neither contract may pay out any amount for 180 days after the transfer date. A withdrawal from either contract within that window risks recharacterization of the entire transfer as a taxable distribution.
Item | Original Contract | New Contract |
Cash value after transfer | $90,000 | $60,000 |
Cost basis after transfer | $54,000 | $36,000 |
Gain after transfer | $36,000 | $24,000 |
180-day distribution restriction | Yes | Yes |
Common mistakes and compliance traps
Accepting a check. The single most expensive mistake. If you receive funds from the old carrier in any form payable to you, the exchange is gone. Corrective action: always instruct the old carrier to make any payment payable to the new carrier, not to you.
Failing to confirm loan treatment. Owners with outstanding loans often assume the loan transfers automatically. It does not. Corrective action: get written confirmation from the new carrier that it will assume the loan before signing the assignment form.
Ignoring the restart of the surrender period. A new 7-year surrender schedule on a contract you may need to access in three years is a serious liquidity trap. Corrective action: map your likely withdrawal needs against the new surrender schedule before proceeding.
Overlooking rider loss. Guaranteed income riders, enhanced death benefits, and long-term care riders on the old contract do not transfer. Corrective action: value each active rider and confirm whether equivalent riders are available on the new contract and at what cost.
Changing the owner or annuitant simultaneously. Any ownership change at the time of the exchange can disqualify the tax-free treatment. Corrective action: complete ownership changes in a separate transaction, before or after the exchange.
Partial exchange followed by a quick withdrawal. Taking money from either contract within 180 days of a partial transfer invites IRS recharacterization. Corrective action: calendar the 180-day window and do not touch either contract until it passes.
Marginal fee savings that do not justify the move. Saving 0.10% per year in fees while paying a 7% surrender charge takes 70 years to break even. Corrective action: run the break-even calculation before signing anything.
An independent broker’s perspective on 1035 exchanges
The most underappreciated risk in a 1035 exchange is not the tax mechanics — those are well-documented and manageable. The real risk is the sales environment around the exchange. Bonus credits are a marketing tool, not a financial benefit, until you model them against the full cost of the new contract over your actual holding period. Most owners who regret an exchange did not lose because of a tax mistake; they lost because the new contract’s surrender schedule or fee structure was never honestly compared to what they gave up.
When I look at an exchange for a client, the first question is not “what does the new contract offer?” It is “what does the current contract cost to leave, and what does the owner lose permanently?” Grandfathered guaranteed income benefits on contracts issued before 2008 can be worth tens of thousands of dollars in present-value terms. Those benefits do not transfer. A 1% bonus on a $200,000 contract is $2,000. A lost GMIB rider that guarantees 5% annual income growth on a $200,000 benefit base is worth far more over a 10-year deferral period. The math is not close.
The 180-day rule on partial exchanges is another area where owners get into trouble without realizing it. The rule sounds simple, but “any amount received under either contract” is broader than most people expect. A required minimum distribution from the original contract within 180 days of a partial transfer can be enough to trigger recharacterization. Plan the timing carefully, and involve a CPA before executing any partial exchange.
A 1035 exchange is a legitimate and often powerful tool. It is also one of the most frequently misused tools in the annuity market, primarily because the incentive structure around it — carrier bonuses, agent commissions on new contracts — does not always align with the owner’s best interest. Use the decision checklist in this article, run the break-even math, and get a second opinion from a CPA on the tax consequences before you sign.
This perspective reflects editorial analysis and general industry experience. It is not personalized tax or investment advice. Consult a CPA or qualified financial advisor for guidance specific to your situation.
How East Two West can help you compare annuity options
Repositioning an annuity is a multi-step process, and the paperwork alone can stall an exchange for weeks if it is not handled correctly. East Two West is an independent practice that pulls quotes from multiple annuity carriers — so you see the actual contract terms, fee structures, and surrender schedules side by side, without a single-carrier sales pitch shaping what you compare.
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For owners considering a 1035 exchange, East Two West will model the net-of-fees comparison across carriers, confirm loan treatment with the receiving carrier before you commit, and coordinate the absolute assignment and transfer paperwork so the exchange stays direct and tax-free. What East Two West does not do: provide tax advice. Your CPA handles the tax consequences; East Two West handles the carrier coordination and contract comparison.
If you are ready to see what a better annuity contract actually looks like for your situation, get a quote at East Two West or compare options across carriers before your next step. Bring the worked examples from this article and your current contract’s surrender schedule to the conversation.
Sources
The following primary authorities and regulatory guidance were used to build this article. Each covers a specific aspect of 1035 exchange rules.
This article is general information, not a substitute for advice from a qualified financial advisor. Consult a qualified financial professional about your own circumstances before acting on anything here.
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