What Is a 1035 Exchange? Tax-Free Annuity Transfers Explained

If you own an annuity or life insurance policy and want to move your money to a different product — perhaps one with lower fees, a better interest rate, or additional features like a long-term care rider — you might assume that cashing out and reinvesting would trigger a large tax bill. In many cases, it would. But the IRS provides a way to transfer between qualifying insurance products without owing any taxes: the 1035 exchange.

Named after Section 1035 of the Internal Revenue Code, this provision has been used for decades to give policyholders the flexibility to upgrade their insurance products without a tax penalty. However, a 1035 exchange comes with rules, and misunderstanding them can lead to unexpected taxes, surrender charges, or the loss of valuable contract features. This guide explains exactly how a 1035 exchange works, what transfers qualify, when it makes sense, and what pitfalls to watch out for.

What Is a 1035 Exchange?

A 1035 exchange is a tax-free transfer of funds from one insurance contract to another qualifying insurance contract. The key word is "exchange" rather than "withdrawal and reinvestment." When done correctly, the IRS does not treat the transaction as a taxable event, which means you do not owe income taxes on any gains that have accumulated inside the original contract.

Without a 1035 exchange, surrendering an annuity with $50,000 in gains would result in $50,000 of ordinary income added to your tax return, plus a potential 10 percent early withdrawal penalty if you are under 59 and a half. A 1035 exchange avoids all of this. Your cost basis (the amount you originally invested) and your deferred gains both transfer to the new contract, and taxes are postponed until you eventually take withdrawals from the new contract.

The funds must transfer directly between insurance companies. This is a critical requirement. If the surrendering insurance company sends a check to you personally, the IRS will treat it as a withdrawal, and you will owe taxes on any gains. The money must go directly from the old company to the new company without passing through your hands.

Eligible 1035 Exchange Transfers

Not every transfer between insurance products qualifies under Section 1035. The IRS specifies which types of exchanges are permitted:

• Annuity to annuity: You can transfer funds from one annuity contract to another annuity contract. This is the most common type of 1035 exchange and is often used to move to a contract with lower fees, a better interest rate, or different features.
• Life insurance to annuity: You can transfer the cash value of a life insurance policy into an annuity. This is useful when you no longer need the death benefit and want to convert the accumulated cash value into retirement income.
• Life insurance to life insurance: You can exchange one life insurance policy for another. This is common when upgrading to a policy with better features or a higher death benefit.
• Annuity or life insurance to long-term care insurance: The Pension Protection Act of 2006 expanded Section 1035 to include tax-free exchanges from annuities or life insurance policies into qualified long-term care insurance contracts. This allows you to reposition assets for potential care needs without triggering taxes.

One direction that is not allowed is exchanging an annuity into a life insurance policy. The IRS prohibits this because it would effectively convert taxable deferred gains into a tax-free death benefit, bypassing income taxes entirely.

When a 1035 Exchange Makes Sense

A 1035 exchange is not always the right move. It makes sense in specific situations where the benefits of the new contract clearly outweigh the costs and disruptions of leaving the old one. Here are the most common reasons people use a 1035 exchange:

Lower fees: Variable annuities can carry annual fees of 2 to 3 percent or more. If you find a contract with substantially lower fees, exchanging can save thousands of dollars over the life of the contract. Even a 1 percent reduction in fees can translate to tens of thousands of dollars in additional growth over 20 years.

Better interest rate or crediting method: If you own a fixed or fixed indexed annuity, rates and crediting methods change over time. A newer contract may offer a higher guaranteed rate or more favorable index crediting terms. For variable annuities, a new contract may offer better investment sub-account options.

Adding a long-term care rider: Some annuity contracts offer optional riders that provide enhanced benefits for long-term care expenses. If your current annuity does not include this feature and you want it, a 1035 exchange to a contract with an LTC rider can add this protection without triggering taxes.

Repositioning for income: If you are approaching retirement and want to convert an accumulation-focused annuity into one with a guaranteed lifetime income rider, a 1035 exchange lets you make this transition without a tax event.

Converting to long-term care coverage: If you own an annuity or life insurance policy you no longer need for its original purpose, exchanging it into a qualified long-term care insurance policy lets you reposition those assets for potential care needs, all without triggering any taxes on the accumulated gains.

Potential Pitfalls and What to Watch Out For

While a 1035 exchange eliminates the tax consequences of switching contracts, it does not eliminate all costs and risks. Here are the most important pitfalls to consider before initiating an exchange:

New surrender period: The new annuity contract will typically have its own surrender schedule, which means the clock resets. If your old contract had two years left on a seven-year surrender period, and the new contract has a new seven-year surrender period, you have just committed to seven more years of restricted access. This is one of the most significant drawbacks of a 1035 exchange and should be weighed carefully against the benefits of the new contract.

Surrender charges on the old contract: If your current annuity is still within its surrender period, the insurance company will deduct the applicable surrender charge from the amount transferred. A surrender charge of 5 to 7 percent on a $200,000 annuity means $10,000 to $14,000 less being transferred to the new contract. In many cases, it is better to wait until the surrender period expires before initiating an exchange.

Loss of existing features: Some older annuity contracts have features that are no longer available in new products, such as higher guaranteed minimum interest rates, more generous income rider terms, or lower mortality and expense charges. Once you exchange out of a contract, you lose these features permanently. Make a detailed comparison of both contracts before proceeding.

Agent churning: Be cautious if an agent is pushing you to exchange your annuity for a new product. Agents earn commissions when you purchase a new contract, which creates a financial incentive to recommend exchanges even when they are not in your best interest. This practice, known as churning, is unethical and may be illegal. If an agent cannot clearly explain how the new contract is materially better for you, consider seeking a second opinion.

How the 1035 Exchange Process Works

The 1035 exchange process is straightforward, but each step must be followed carefully to maintain the tax-free treatment:

1. Review your current contract. Check your surrender schedule, existing features, guaranteed rates, and any outstanding loan balances. Determine whether the exchange makes financial sense after accounting for any surrender charges.
2. Compare the new contract. Evaluate the new annuity's fees, interest rates or crediting methods, surrender schedule, available riders, and the financial strength of the issuing company. Ensure the new contract is genuinely better for your goals.
3. Complete the exchange paperwork. The receiving insurance company will provide 1035 exchange forms. You will sign a request to transfer the funds directly from the old company to the new company. Make sure the paperwork specifies that this is a 1035 exchange.
4. Direct transfer of funds. The old insurance company sends the funds directly to the new insurance company. The money should never pass through your hands. This direct transfer is what preserves the tax-free treatment.
5. Confirm the new contract. Once the funds arrive at the new company, your new annuity contract is issued. Review all the details to make sure they match what you were promised. You will have a free-look period (typically 10 to 30 days) during which you can cancel the new contract and receive a full refund.

The entire process typically takes two to four weeks. During this time, your money is in transit and may not be earning interest. Some companies will credit interest retroactively once the exchange is complete, but this varies. Ask both companies about their policies before initiating the transfer.

Cost Basis and Tax Implications After the Exchange

One of the most important aspects of a 1035 exchange is that your cost basis carries over from the old contract to the new one. Your cost basis is the total amount of after-tax money you invested in the original annuity. Because the exchange is tax-free, the IRS requires that the new contract inherit the same cost basis. This means you are not losing any of your tax-free recovery of premium.

For example, if you invested $100,000 in your original annuity and it grew to $150,000, your cost basis is $100,000 and your gain is $50,000. After a 1035 exchange, the new contract holds $150,000 with the same $100,000 cost basis and $50,000 in deferred gains. When you eventually take withdrawals from the new contract, the gains will be taxed as ordinary income under the normal LIFO rules.

The insurance companies involved in the exchange will report the transaction to the IRS. The surrendering company typically issues a Form 1099-R with a code indicating a 1035 exchange, and the receiving company records the transferred cost basis. Keep records of all exchange documentation for your tax files.

Making the Right Decision

A 1035 exchange is a powerful tool, but it is only beneficial when the new contract genuinely improves your financial position. Before initiating an exchange, ask yourself these questions: Will the new contract have lower total fees? Does it offer features I need that my current contract lacks? Have I accounted for any surrender charges on the old contract? Am I comfortable restarting a new surrender period? Am I giving up any valuable guarantees or features in my current contract?

If the answers point clearly in favor of the new contract, a 1035 exchange can save you a significant amount in taxes while giving you a better product. If the answers are mixed, take your time and compare carefully. Consult a financial advisor who can review both contracts objectively and a tax professional who can help you understand any implications specific to your situation. The goal is to make sure the exchange serves your long-term interests, not just a short-term interest rate or a sales pitch.