1035 Exchange vs. Surrendering and Buying a New Policy? (w/Examples) + FAQs

This article reflects federal rules as of June 2026 and covers tax year 2025 (the 2026 filing season). IRC Section 1035 is a permanent provision, not a temporary 2025-law (OBBBA) item. State conformity varies — confirm current figures with your state before you act. This is educational information, not personal tax, legal, or insurance advice for your specific contract.

Quick Answer

A 1035 exchange lets you swap one life insurance or annuity contract for a similar new one with no tax on the built-in gain, because your cost basis carries over. Surrendering the old policy first and buying a new one instead triggers ordinary income tax on every dollar of gain in the year you surrender.

The difference is not small. When you surrender a contract with a large gain, the insurer cuts you a check, sends you a Form 1099-R, and the IRS taxes the gain at your ordinary income rate — the same brackets that apply to wages for tax year 2025. A direct 1035 exchange moves the money insurer-to-insurer, so you never touch the cash, the gain stays deferred, and the new contract simply inherits your old basis.

The stakes are real because the choice is often irreversible once the check clears. According to the industry group LIMRA’s 2024 annuity sales data, U.S. annuity sales hit a record $432.4 billion in 2024, and a large share of those dollars are people moving money between contracts — many of whom never learn that how they move it decides whether they owe tax.

Here is what you will learn:

🔄 What a 1035 exchange is, which contract swaps qualify, and the one-way street rule that traps annuity owners.
💸 The exact tax math: a fully worked example showing the dollars saved by exchanging instead of surrendering.
⚠️ The policy-loan “boot” trap that quietly turns a tax-free move into a taxable one.
🧾 How the exchange shows up on Form 1099-R (Code 6), and when you must — and need not — report it.
✅ A step-by-step decision aid, deadlines, costs, mistakes to avoid, and 12 FAQs to settle your case.

What a 1035 Exchange Actually Is

A 1035 exchange is named after Section 1035 of the Internal Revenue Code, the federal tax law that lets you trade certain insurance contracts without paying tax on the gain. The plain idea: if you are simply replacing one insurance or annuity product with a similar one, the government does not treat that as “cashing out.” You never had use of the money, so there is nothing to tax — yet.

The gain you are protecting is the difference between your contract’s cash value and your basis. Your basis is the total of premiums you paid minus any amounts you already took out tax-free. If you paid $50,000 in premiums and the cash value grew to $80,000, you have a $30,000 gain sitting inside the contract. Surrender it, and that $30,000 becomes ordinary income this year. Exchange it under Section 1035, and the $30,000 stays untaxed inside the new contract.

The single most important mechanical rule is that the money must move directly between insurance companies. As the IRS explains in Publication 575, and as tax practitioners confirm in writeups like this one on Section 1035 exchange requirements, the transaction must be a direct exchange with no “constructive or actual receipt of funds by the policyholder.” If the old insurer mails you the cash, even for a day, the IRS treats it as a surrender — and the tax-free protection is gone. The consequence of getting this wrong is a full tax bill on the gain. A common misconception is that you can take the check, then deposit it into a new policy within 60 days like an IRA rollover. You cannot — non-qualified annuities have no 60-day rollover rule. What you should do is sign the new insurer’s 1035 exchange paperwork and let the two companies handle the transfer; never request a check payable to yourself.

Which Contract Swaps Qualify (and the One-Way Street)

Section 1035 only protects swaps between similar contract types, and the rules run in one direction for annuities. Knowing your starting contract tells you exactly where you can go.

The qualifying exchanges, drawn directly from the statute and IRS Publication 575, are:

Life insurance → another life insurance policy, an endowment, an annuity, or a qualified long-term care (LTC) policy.
Endowment → another endowment (with payments starting no later than the old one), an annuity, or a qualified LTC policy.
Annuity → another annuity or a qualified LTC policy.

The annuity one-way rule

You can exchange a life insurance policy into an annuity, but you can never exchange an annuity into a life insurance policy. This is the “one-way street.” The reason is tax design: life insurance death benefits are generally income-tax-free, and Congress will not let you convert taxable annuity gain into a tax-free death benefit. The consequence of attempting it is that the transaction fails Section 1035 entirely and the annuity gain becomes taxable. For example, if Maria owns a non-qualified annuity with a $25,000 gain and tries to roll it into a universal life policy, the IRS treats the move as a full surrender and taxes the $25,000 as ordinary income. What Maria should do instead is exchange the annuity for a better annuity or a qualified LTC policy — both of which are allowed.

The long-term care option

Since the Pension Protection Act, you can exchange a life insurance policy or a non-qualified annuity directly into a tax-qualified LTC policy under IRC Section 7702B. This is powerful because annuity gains that would otherwise be taxable can fund LTC coverage with no tax. The catch is that the LTC policy must be “tax qualified,” and the funds must transfer directly to the LTC insurer. If you withdraw the cash yourself to pay LTC premiums, you lose the exchange treatment and owe tax on the gain.

The Core Comparison: Exchange vs. Surrender-and-Rebuy

Both routes end with you holding a new contract. Only one of them sends a tax bill. Here is how they differ on every dimension that matters.

Factor	1035 Exchange	Surrender, Then Buy New
Tax on the gain	None now — gain is deferred into the new contract	Full gain taxed as ordinary income this year
Cost basis	Old basis carries over to the new contract	Resets; you start fresh with the new premiums
Money flow	Direct, insurer-to-insurer; you never touch it	Insurer pays you, then you buy separately
Form 1099-R	Issued with Code 6, taxable amount $0	Issued with a taxable distribution code; gain in Box 2a
10% early penalty (annuities)	Not triggered by the exchange itself	May apply if you are under age 59½
MEC status	A MEC stays a MEC; status carries over	New policy tested fresh, but you paid tax to get there
Flexibility	Limited to qualifying like-kind swaps	Total freedom — but at full tax cost

The carryover-basis point deserves a closer look. In a 1035 exchange, your cost basis in the old policy carries over to the new policy. This even works in your favor when the basis is higher than the cash value — a “loss” position. If you paid $90,000 in premiums but the cash value dropped to $70,000, a 1035 exchange lets you carry the higher $90,000 basis into the new contract, preserving future tax-free withdrawal room you would forfeit by surrendering.

Worked Example: The Dollars on the Line

Numbers make the choice obvious. Meet David, age 62, who owns an old universal life policy he wants to replace with a better-priced one.

David’s situation for tax year 2025:

Cash value: $80,000
Total premiums paid (basis): $50,000
Built-in gain: $80,000 − $50,000 = $30,000
David’s marginal federal ordinary income rate: 24% (a common bracket for 2025)

Route 1 — He surrenders, then buys new. The insurer pays David $80,000 and reports a $30,000 taxable distribution on Form 1099-R. David adds $30,000 to his income. His federal tax is $30,000 × 24% = $7,200. If David’s state taxes the gain at, say, 5%, that adds another $1,500, for a total tax of $8,700. He then has roughly $71,300 left to buy the new policy.

Route 2 — He does a 1035 exchange. The full $80,000 moves directly from the old insurer to the new one. The 1099-R shows Code 6 with $0 taxable. David pays $0 in tax, keeps the full $80,000 working, and his $50,000 basis carries into the new contract.

The 1035 exchange saves David $8,700 and keeps an extra $8,700 of cash value compounding. That gap is the entire reason Section 1035 exists.

The Policy-Loan “Boot” Trap

This is the mistake that catches careful people, so it gets its own section. Boot is any non-like-kind value you effectively receive in an exchange — and a forgiven policy loan counts.

If your old policy carries an outstanding loan and the new contract does not pick it up, the IRS treats the wiped-out loan as money in your pocket. As Tax Facts explains on policy loans and 1035 exchanges, the net reduction in your loan is “boot” and is taxable as ordinary income to the extent there is gain in the contract. The consequence is a surprise tax bill on a transaction you thought was tax-free.

Consider Janet, who has a whole life policy with $60,000 cash value, $40,000 basis (a $20,000 gain), and a $15,000 outstanding loan. She does a 1035 exchange into a new policy that does not carry the loan. The $15,000 loan reduction is boot, and because she has $20,000 of gain, the full $15,000 is taxed as ordinary income. At a 22% rate, that is $3,300 she did not expect.

A second, sneakier version: paying off the loan from cash value right before the exchange. Practitioners warn that repaying the loan from policy cash values as part of the exchange can be taxable, because the IRS may treat the payoff and the exchange as one integrated transaction. The common misconception is “I’ll just clear the loan first, then exchange clean.” That can backfire. What you should do, per guidance on exchanges with policy loans, is either repay the loan with outside cash (not policy value), wait a reasonable period before exchanging, or have the new insurer carry the loan over so there is no net reduction.

The MEC Trap That Travels With You

A Modified Endowment Contract (MEC) is a life insurance policy that was funded too fast and failed the federal “7-pay test.” The penalty for MEC status is that withdrawals and loans come out gain-first and taxable, plus a possible 10% penalty before age 59½ — the opposite of how normal life insurance is taxed.

Here is the trap: a 1035 exchange cannot wash a MEC clean. As Prudential’s MEC guidance states, a contract received in exchange for a MEC “will also be a MEC.” So if your old policy is a MEC, the shiny new policy is born a MEC too. The consequence is that you carry the worse tax treatment forever, even after the swap.

The flip side also matters. Even a non-MEC policy gets re-tested at issue. Section 7702A requires all contracts to be tested at issue, so if you add new premium during the exchange and the new, often smaller, policy fails the 7-pay test, you can create a MEC by accident. What you should do is ask the new insurer to confirm the policy’s MEC status in writing before you sign, and avoid dumping extra premium into the new contract during the 7-pay window.

Surrender Charges: The Other Cost of Leaving

Tax is not the only price of moving. Many annuities and some cash-value life policies carry a surrender charge — a penalty the insurer keeps if you leave during the early years. This cost hits the same whether you surrender outright or do a 1035 exchange, because both close the old contract.

Surrender charges usually follow a declining schedule. A typical 7-year annuity surrender schedule looks like this:

Contract Year	Surrender Charge
Year 1	7%
Year 2	6%
Year 3	5%
Year 4	4%
Year 5	3%
Year 6	2%
Year 7	1%
Year 8+	0%

Some contracts start as high as 8% or more in year one, with periods running eight to ten years. On an $80,000 contract in year three at 5%, that is a $4,000 charge gone for good. What you should do is check your contract’s exact schedule, and if you are close to the end of the surrender period, wait until it hits 0% before exchanging — the tax-free exchange still does not refund a surrender charge.

Partial 1035 Exchanges and the 180-Day Rule

You do not have to move the whole contract. A partial 1035 exchange lets you split off part of an annuity’s cash value into a new annuity, tax-free. This is useful for diversifying across insurers or carving out a piece for an income strategy.

The catch is a waiting period. Under Revenue Procedure 2011-38, a partial annuity exchange is tax-free only if you take no withdrawal from either contract during the 180 days after the transfer (with a narrow exception for payments made as a life annuity or over 10+ years). The consequence of pulling money out inside that 180-day window is that the IRS can recharacterize the whole partial exchange as a taxable distribution. So if Tom does a partial exchange and then takes a $5,000 withdrawal on day 90, he risks blowing the tax-free treatment on the entire transfer. What Tom should do is mark the 180th day on his calendar and leave both contracts untouched until it passes.

Which Situation Applies to You?

The right move depends on what you hold and why you are moving. Find your case below.

You own a life insurance policy with a gain and want better pricing or features. A 1035 exchange into a new life policy or annuity is usually the clear winner — you keep the gain deferred. Read the boot and MEC sections before you sign.
You own a non-qualified annuity and found a better annuity. Use a 1035 exchange annuity-to-annuity. Remember you can never go to life insurance.
You are under age 59½ with an annuity. Surrendering can trigger a 10% early-distribution penalty on the gain on top of income tax; a 1035 exchange avoids triggering it.
You have an outstanding policy loan. Stop and plan the loan first, or you may owe tax on boot. Consider professional help here.
Your contract is a MEC. Exchanging will not fix it. Decide if the new contract’s benefits justify keeping MEC tax treatment.
You need long-term care coverage and have an old annuity. A 1035 exchange into a qualified LTC policy can fund coverage with otherwise-taxable gain — a strong, underused option.

How It’s Reported: Form 1099-R and Code 6

Even though a proper 1035 exchange is not taxable, it is often still reported. The insurer issues a Form 1099-R with distribution Code 6 in Box 7. Per IRS distribution-code guidance, Code 6 means “tax-free exchange of life insurance, annuity, long-term care insurance, or endowment contracts under section 1035.”

On a clean exchange, Box 2a (taxable amount) should show $0.00. The exchange is reportable income but not taxable income — your tax software lists it but excludes it from taxable income, typically flowing through Form 1040 line 4b as $0. Reporting is not required at all if the exchange happens within the same company, is purely contract-for-contract, and the company keeps adequate basis records, per Form 1099-R instructions on 1035 exchanges. If you ever see a Code 6 form with a dollar amount in Box 2a, that signals boot — and that part is taxable. What you should do when a Code 6 form arrives is enter it as your software directs and confirm Box 2a is $0; if it is not, ask the insurer why before you file by the April 15, 2026 deadline.

Step-by-Step: How to Do a 1035 Exchange Right

Pick the new contract first. You exchange into a specific policy, so choose the new insurer and product before touching the old one.
Confirm the swap qualifies. Match your starting contract to the allowed list; never aim an annuity at life insurance.
Use the new insurer’s 1035 forms. They send an “absolute assignment” and 1035 exchange request to the old insurer. You sign — you do not request a check to yourself.
Handle any loan deliberately. Decide whether to carry the loan, repay it with outside cash, or wait, to avoid boot.
Check the surrender schedule and MEC status. Time the move past the surrender period if possible; get MEC status in writing.
Let the companies transfer the funds. The cash moves insurer-to-insurer; the old contract is canceled.
Keep the 1099-R and your basis records. File the Code 6 form, confirm $0 in Box 2a, and keep premium records to prove basis later.

The process typically takes 2 to 6 weeks for the carriers to transfer funds. A DIY exchange through the new insurer usually costs nothing in fees beyond any surrender charge; complex cases (loans, MECs, partial exchanges, estate-owned policies) warrant a CPA or insurance-tax attorney, often $300–$1,000+, which is cheap next to a wrong tax bill.

Mistakes to Avoid

Taking the check yourself. It turns the whole exchange into a taxable surrender — the entire gain becomes income.
Ignoring an outstanding loan. A wiped-out loan is boot, taxed as ordinary income up to the contract’s gain.
Paying off a loan from cash value right before exchanging. The IRS may treat it as one taxable transaction.
Assuming a 1035 exchange clears MEC status. It does not; the new contract inherits MEC treatment.
Adding new premium during the 7-pay window. You can accidentally turn a fresh policy into a MEC.
Surrendering an annuity before age 59½. You stack a 10% early-distribution penalty on top of income tax.
Exchanging an annuity into life insurance. The one-way rule voids the exchange and taxes the gain.
Taking a withdrawal within 180 days of a partial exchange. It can void the tax-free treatment on the whole transfer.
Forgetting surrender charges. They apply to exchanges too and are never refunded.

Do’s and Don’ts

Do route the funds insurer-to-insurer — why: receiving the money yourself destroys the tax shelter.
Do confirm your new contract’s MEC and surrender status in writing — why: both follow you and cannot be undone later.
Do keep complete premium records — why: they prove your carried-over basis years from now.
Do time the move past the surrender period when feasible — why: surrender charges are pure lost money.
Do call a tax pro when a loan, MEC, or partial exchange is involved — why: these are the exact spots that create surprise tax.
Don’t exchange an annuity into life insurance — why: it is never allowed and triggers full tax.
Don’t withdraw within 180 days of a partial annuity exchange — why: it can void the exchange.
Don’t assume a 60-day rollover applies to annuities — why: it does not; only a direct 1035 exchange works.
Don’t chase features without checking surrender charges — why: the penalty can erase the new policy’s benefit.
Don’t ignore a Box 2a dollar figure on a Code 6 form — why: it flags taxable boot you must report.

Pros and Cons of a 1035 Exchange

Pro — Defers tax on the gain why: you keep 100% of cash value compounding instead of paying tax now.
Pro — Carries over your basis why: it preserves tax-free withdrawal room, even in a loss position.
Pro — Avoids the 10% annuity penalty why: the exchange itself is not an early distribution.
Pro — Enables LTC funding why: otherwise-taxable annuity gain can buy qualified LTC coverage tax-free.
Pro — Lets you upgrade products why: you can move to lower-cost or better-featured contracts without a tax hit.
Con — Limited to like-kind swaps why: you cannot move to non-qualifying products like an annuity-to-life jump.
Con — Surrender charges still apply why: leaving the old contract early costs the same as a surrender.
Con — MEC status carries over why: you cannot escape bad tax treatment by exchanging.
Con — Loan boot risk why: outstanding loans can quietly create taxable income.
Con — New surrender period restarts why: the new contract often locks you in again for years.

What to Do Next

Pull your current contract values — cash value, total premiums paid (basis), any outstanding loan, and your surrender schedule.
Identify the new contract you want and confirm the swap is allowed under Section 1035.
Request the 1035 exchange paperwork from the new insurer — never ask the old insurer for a check.
Resolve any loan with outside cash, a carryover, or a waiting period before you initiate.
Get MEC and surrender-charge status in writing before signing.
File the Code 6 Form 1099-R with your 2025 return by April 15, 2026, and confirm Box 2a is $0.
Call a CPA or insurance-tax attorney if you have a loan, a MEC, a partial exchange, or an estate-owned policy.

Frequently Asked Questions

Is a 1035 exchange taxable? No. A properly executed 1035 exchange is not taxable, because gain is deferred and your basis carries over. You may receive a Form 1099-R with Code 6, but Box 2a should show $0 taxable for tax year 2025.

Can I exchange an annuity for a life insurance policy? No. The annuity-to-life direction is never allowed under Section 1035. You can exchange an annuity only for another annuity or a qualified long-term care policy; attempting a life-insurance swap triggers full tax on the gain.

What is “boot” in a 1035 exchange? Boot is any non-like-kind value you effectively receive, most often a forgiven policy loan. Boot is taxed as ordinary income up to the amount of gain in the contract, even within an otherwise tax-free exchange.

Does a 1035 exchange reset my cost basis? No. Your old basis carries over to the new contract. If your basis is higher than your cash value, you keep that higher basis — an advantage you lose by surrendering instead.

Will a 1035 exchange fix a Modified Endowment Contract? No. A contract received in exchange for a MEC stays a MEC. The new policy inherits the same gain-first, taxable withdrawal treatment, so an exchange cannot wash MEC status clean.

Do I avoid surrender charges with a 1035 exchange? No. Surrender charges apply to a 1035 exchange just as they do to a surrender, because the old contract is closed. Check your schedule and consider waiting until charges reach 0%.

Which Form 1099-R code reports a 1035 exchange? Code 6 in Box 7. It signals a tax-free exchange under Section 1035, and a clean exchange shows $0 in Box 2a. A dollar amount there means taxable boot.

Can I do a partial 1035 exchange? Yes. You can split part of an annuity into a new annuity tax-free. But under Revenue Procedure 2011-38, taking a withdrawal within 180 days can void the tax-free treatment of the whole transfer.

Does a 1035 exchange trigger the 10% early withdrawal penalty? No. The exchange itself is not an early distribution, so it does not trigger the 10% penalty for those under age 59½. Surrendering an annuity early, by contrast, can.

How long does a 1035 exchange take? Usually 2 to 6 weeks for the insurers to transfer funds and cancel the old contract. Timing varies by carrier and whether a loan or partial exchange is involved.

Do all states follow the federal 1035 rules? Most do, because the gain deferral happens at the federal level and flows into state taxable income. But state conformity is not guaranteed — confirm your state’s treatment, especially if it does not start from federal taxable income.

Can I 1035 exchange a life insurance policy into long-term care coverage? Yes. Since the Pension Protection Act, you can exchange a life policy or non-qualified annuity directly into a tax-qualified LTC policy under Section 7702B, funding coverage with otherwise-taxable gain.

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