Can a 1035 Exchange Pull Annuity Gains Out Tax-Free for LTC? (w/Examples) + FAQs

This article reflects federal rules as of June 2026 and covers tax years 2025 and 2026. State rules vary and are addressed separately below. Tax law changes — confirm current figures with the IRS or a licensed professional before you act.

Quick Answer

Yes. For tax years 2025 and 2026, a properly done Section 1035 exchange lets you move a non-qualified annuity — including its taxable gain — directly into qualified long-term care (LTC) coverage. The gain is never taxed when later spent on care.

A 1035 exchange is the only way to pull the gain out of a non-qualified annuity without paying ordinary income tax on it. Normally, when you cash out an annuity, every dollar of growth above your basis is taxed as ordinary income — and if you are under 59½, a 10% penalty may also apply. By exchanging that annuity straight into a tax-qualified LTC contract under the Pension Protection Act of 2006, the gain rides along untouched and disappears for tax purposes once it pays for care.

This matters because long-term care is the single largest unplanned cost most retirees face. About 70% of people turning 65 will need some form of long-term care, and a private room in a nursing home now runs well over $100,000 a year. If you are sitting on an annuity you no longer need, this strategy turns dormant, tax-burdened money into care coverage you may actually use.

Here is what you will learn:

• 💡 How a 1035 exchange erases an annuity’s taxable gain when it funds LTC coverage
• ⚖️ Why this only works for non-qualified annuities — and never for IRA or 401(k) money
• 🧮 Three fully worked dollar examples showing the exact tax saved
• 📋 The forms, the 180-day partial-exchange rule, and the 1099-R code that proves it was tax-free
• 🚫 Seven costly mistakes that turn a “tax-free” exchange into a surprise tax bill

What a 1035 Exchange to LTC Actually Is

A 1035 exchange is a swap of one insurance or annuity contract for another that the tax code treats as a continuation, not a sale. Because the IRS does not see it as a cash-out, no gain is recognized at the moment of transfer. The name comes from Section 1035 of the Internal Revenue Code, the rule that defines which swaps qualify.

Before 2010, you could use a 1035 exchange to trade one annuity for another, or a life policy for an annuity — but not an annuity for long-term care insurance. The Pension Protection Act of 2006 changed that, and the change took effect on January 1, 2010. Since then, you can exchange a non-qualified annuity directly into a tax-qualified LTC contract, and the annuity’s built-in gain comes along tax-free.

The reason this is so powerful is the way LTC benefits are taxed. Benefits paid by a tax-qualified LTC contract under Section 7702B are generally received income-tax-free. So the gain that would have been taxed as ordinary income inside the annuity is never taxed at all once it flows out as care benefits. You are not just deferring the tax — you are eliminating it.

The Three Contracts Section 1035 Allows

Section 1035 lists exactly which exchanges keep their tax-free status, and the rule runs in one direction. You can move “up” the ladder toward LTC, but you can never exchange an LTC or annuity contract back into a plain annuity tax-free. Knowing the allowed paths keeps you from triggering a taxable event by accident.

The permitted tax-free exchanges include an annuity for another annuity, an annuity for a qualified LTC contract, a life insurance policy for an annuity or LTC contract, and one LTC contract for another. The path that matters here is annuity-to-LTC. The consequence of getting the direction wrong is that the entire gain becomes taxable in the year of the swap.

Tax-Qualified vs. Non-Tax-Qualified LTC Contracts

Only a tax-qualified LTC contract delivers the tax-free result. A tax-qualified contract meets the standards in Section 7702B, which include specific trigger rules — you must be unable to do at least two activities of daily living for 90 days, or need supervision due to cognitive decline. Almost every LTC product sold today is tax-qualified, but you should confirm it in writing.

If you exchange into a non-tax-qualified contract, the 1035 protection does not apply and benefits may be taxable. The misconception here is that “all LTC insurance is the same.” It is not. Always ask the carrier to confirm the contract is tax-qualified under Section 7702B before you sign.

How the Two Product Types Work

There are two very different destinations for your annuity money, and they are taxed and funded in completely different ways. Picking the wrong one for your situation can waste the strategy. Below is how each behaves once your exchanged dollars land inside it.

The first option is a standalone tax-qualified LTC insurance policy, where you pay an annual premium for pure coverage. The second is a hybrid, or “linked-benefit,” annuity with an LTC rider, where your money stays in an account and can pay for care at a multiplied rate. Each fits a different reader, which is why the decision aid below matters.

Product Type	How Your Exchanged Annuity Funds It
Standalone tax-qualified LTC policy	The gain pays annual premiums tax-free as charges are drawn down over time, often over several years
Hybrid (linked-benefit) annuity with LTC rider	The full amount, gain included, moves into one account that pays LTC benefits at a leveraged multiple, with remaining value still available

Standalone LTC Insurance Funded by 1035

With a standalone policy, your annuity money sits in a “1035 funding account,” and the insurer pulls each year’s premium from it tax-free until the balance runs out. Each premium charge that comes from the annuity gain escapes the ordinary-income tax you would otherwise owe. The plain-English benefit is that a one-time annuity becomes a multi-year stream of paid premiums without a tax bill.

The consequence of choosing this route is that coverage can lapse if the funding account empties before you stop paying premiums. A reader should ask the carrier how many years the exchanged amount will cover. If care is never needed, standalone premiums are generally not refunded — that is the trade-off for lower cost.

Hybrid Annuities with an LTC Rider

A hybrid annuity keeps your money in an account you still control, while an LTC rider can pay out two to three times that account value for qualified care. Because it is built on Section 7702B, qualified LTC payments come out income-tax-free, including the original annuity gain. The appeal is leverage plus a safety net — if you never need care, the account passes to heirs.

The consequence is cost: hybrids tie up a larger lump sum and may grow slowly. The misconception is that the LTC payout is “free money.” It is not — you are spending your own principal and gain first, with the rider multiplying coverage beyond it. A reader should compare the total LTC benefit pool against the lump sum committed.

Why This Only Works for Non-Qualified Annuities

This is the most important rule in the entire article, and getting it wrong is the most common and most expensive error. Section 1035 applies only to non-qualified annuities — money you funded with after-tax dollars outside a retirement plan. It does not apply to annuities held inside an IRA, 401(k), 403(b), or other qualified retirement account.

The reason is that qualified-account money has never been taxed, so there is no “basis and gain” structure for Section 1035 to preserve. Moving qualified money requires a trustee-to-trustee rollover, not a 1035 exchange. If you try to 1035 an IRA annuity into an LTC contract, the IRS treats the withdrawal as a fully taxable distribution, and you may owe tax on the entire amount plus a penalty.

The practical test is simple: if you got a tax deduction or used pre-tax dollars when you funded the annuity, it is qualified and off-limits for this strategy. If you funded it with money you had already paid tax on — savings, an inheritance, a maturing CD — it is non-qualified and eligible. When in doubt, ask the issuing carrier whether the contract is qualified or non-qualified before you start.

Which Situation Applies to You?

The right move depends on your annuity, your age, and whether you actually want LTC coverage. Use these branches to find the path that fits, then read the matching section above.

• You hold a non-qualified annuity with a large gain and want LTC coverage: This strategy is built for you — choose a standalone policy or a hybrid based on whether you want pure coverage or leverage-plus-inheritance.
• Your annuity is inside an IRA or 401(k): A 1035 exchange does not apply; explore qualified rollovers or paying LTC premiums separately, and talk to a CPA.
• You are under 59½ and need the money soon: A 1035 exchange avoids the 10% early-withdrawal penalty on the gain, but the money is now locked into LTC use.
• You want flexible cash, not care coverage: A 1035 exchange may be the wrong tool — converting to a SPIA or another annuity keeps liquidity but does not erase the gain.
• Your annuity has little or no gain: The tax benefit is small; weigh whether the LTC coverage itself is worth the exchange.

Worked Examples With Real Dollars

Numbers make the benefit concrete. Each example below uses round figures and the 2025/2026 federal rules, so you can copy the math against your own contract.

Example 1 — The Idle Annuity (Standalone LTC)

Margaret, age 68, owns a non-qualified deferred annuity worth $200,000, with a cost basis of $120,000 and a gain of $80,000. She no longer needs the annuity and worries about future care costs.

If Margaret simply cashed out, the $80,000 gain would be taxed as ordinary income. In a 24% federal bracket, that is $80,000 × 24% = $19,200 in federal tax, leaving her with about $180,800. Instead, she does a 1035 exchange of the full $200,000 into a tax-qualified LTC policy. The $80,000 gain transfers tax-free, the insurer draws annual premiums from the funding account, and when those premiums pay for care, the gain is never taxed. Tax saved: $19,200.

Example 2 — Leverage With a Hybrid (Linked-Benefit)

Robert, age 70, has a $150,000 non-qualified annuity with a $90,000 basis and a $60,000 gain. He wants care coverage but also wants his money to pass to his kids if he never needs care.

Robert 1035-exchanges the full $150,000 into a hybrid annuity with an LTC rider that pays a 3x benefit multiple. His LTC benefit pool becomes roughly $450,000, all payable income-tax-free for qualified care. The $60,000 gain that would have cost him $14,400 in tax at a 24% rate rides in untaxed. If he never needs care, the remaining account value passes to his heirs. Tax avoided on the gain: $14,400, plus leveraged coverage.

Example 3 — Partial Exchange and the 180-Day Trap

Susan, age 66, has a $300,000 non-qualified annuity with a $100,000 gain. She wants to keep half as an annuity and exchange half into an LTC contract.

Under Revenue Procedure 2011-38, a partial 1035 exchange is allowed and is treated pro-rata: she moves $150,000, carrying $50,000 of gain into the LTC contract tax-free. But she must not take a non-annuity withdrawal from either contract for 180 days. If Susan pulls $20,000 from the remaining annuity on day 90, the IRS can collapse the whole transaction and tax the $50,000 gain. Waiting the full 180 days preserves the tax-free result.

Scenario Tables

The three situations below are the ones most readers face. Each shows the choice and the tax result that follows.

Your Choice	Tax Result
Cash out a $200,000 annuity with $80,000 gain	$80,000 taxed as ordinary income now, roughly $19,200 federal tax at 24%
1035 exchange the same annuity into qualified LTC	$80,000 gain transfers tax-free and is never taxed when spent on care
Surrender for cash before age 59½	Gain taxed as income plus a 10% early-withdrawal penalty on the gain

Annuity Source	Eligibility for 1035 to LTC
Non-qualified annuity (after-tax money)	Eligible — gain transfers tax-free under Section 1035
Annuity inside an IRA or 401(k)	Not eligible — a 1035 exchange does not apply to qualified money
Inherited non-qualified annuity (non-spouse)	Generally not eligible for 1035 treatment; confirm with the carrier

Partial-Exchange Action	Consequence
Wait the full 180 days before any non-annuity withdrawal	The partial exchange stays tax-free under Rev. Proc. 2011-38
Take a lump withdrawal within 180 days	The IRS can void the exchange and tax the transferred gain
Take distributions only as a life or 10+ year annuity	Allowed within the 180-day window without breaking the exchange

The Forms, Codes, and Deadlines

A 1035 exchange must be a direct insurer-to-insurer transfer — the money can never touch your hands. According to the cited carrier guidance and IRS reporting rules, if you receive the cash and then re-deposit it, the IRS treats it as a taxable distribution, not an exchange. You start the process by completing the new carrier’s 1035 exchange request form, which authorizes the old carrier to send funds directly.

After the transfer, the old carrier issues a Form 1099-R. The proof that the swap was tax-free is the code in Box 7: code “6” marks a tax-free Section 1035 exchange, and Box 2a (the taxable amount) should show $0.00. You still report the 1099-R on your return even though none of it is taxable, so the IRS sees the matching record.

On timing and cost: a direct exchange usually settles in two to six weeks, depending on the carriers. There is no IRS filing fee, and reputable carriers do not charge for the exchange itself — but watch for surrender charges on the old annuity, which can run several percent in early years. For a partial exchange, mark your calendar for the 180-day window from Revenue Procedure 2011-38 and avoid any non-annuity withdrawal until it closes.

Federal vs. State Treatment

Start with the federal baseline: under Sections 1035 and 7702B, the exchange is tax-free at the federal level and the LTC benefits come out federally income-tax-free. That federal treatment is the same in all 50 states. The open question is whether your state follows the same rules for its own income tax.

Most states with an income tax conform to the federal treatment of 1035 exchanges and tax-qualified LTC benefits, so you generally owe no state tax on the transferred gain either. States vary, though, and some offer extra incentives — a number of states grant a state income-tax deduction or credit for LTC premiums beyond the federal limits. Nine states have no broad personal income tax at all, including Florida, Texas, and Washington, so the state question simply does not arise there.

The consequence of assuming your state conforms when it does not is an unexpected state tax bill. Because conformity and LTC credits differ widely, confirm the rule with your state’s department of revenue before you act. This is one spot where a quick check with a local CPA pays for itself.

A Note on Deducting the Premiums

A common misconception is that you can both 1035-exchange money into LTC and deduct those premiums as a medical expense. You generally cannot double-dip. Premiums paid out of the tax-free exchanged funds are not separately deductible, because that money was never taxed on the way in.

For context, when you pay LTC premiums with regular after-tax dollars, the IRS caps the deductible amount by age, and only the portion of total medical expenses above 7.5% of your AGI counts. The 2026 eligible LTC premium limits rise to $500 (age 40 or less), $930 (41–50), $1,860 (51–60), $4,960 (61–70), and $6,200 (over 70). These limits matter for premiums you pay directly — not for premiums funded by a 1035 exchange.

Funding Method	Premium Deductibility
Paid with 1035-exchanged annuity funds	Not separately deductible — the gain was already shielded from tax
Paid with regular after-tax dollars	Deductible up to the age-based limit, above the 7.5% AGI floor

Mistakes to Avoid

Each error below has turned an intended tax-free move into a tax bill or lost coverage.

• Taking the cash yourself. If the old carrier sends you a check, the IRS treats it as a taxable surrender, not an exchange — the entire gain becomes taxable.
• Using IRA or 401(k) annuity money. A 1035 exchange does not apply to qualified money, so the attempt creates a fully taxable distribution and possibly a penalty.
• Exchanging into a non-tax-qualified LTC contract. Without Section 7702B status, the tax-free benefit protection is lost and payouts may be taxable.
• Breaking the 180-day rule on a partial exchange. A withdrawal inside the window can void the exchange and tax the transferred gain.
• Ignoring surrender charges. Exchanging an annuity still in its surrender period can cost several percent of the value, wiping out the tax savings.
• Forgetting to report the 1099-R. Even though code “6” is tax-free, leaving it off your return can trigger an IRS notice.
• Trying to deduct premiums funded by the exchange. Double-dipping on a deduction for already-shielded money can draw an audit adjustment.

Do’s and Don’ts

• Do confirm in writing that your annuity is non-qualified before starting — eligibility depends entirely on this.
• Do use a direct insurer-to-insurer transfer — touching the cash breaks the tax-free treatment.
• Do verify the LTC contract is tax-qualified under Section 7702B — only then are benefits tax-free.
• Do check for surrender charges first — they can erase the tax savings.
• Do keep your code “6” Form 1099-R with your tax records — it is your proof of a tax-free swap.
• Don’t withdraw from either contract within 180 days of a partial exchange — it can void the deal.
• Don’t assume your state conforms — confirm with your state revenue agency.
• Don’t try to exchange qualified retirement annuities — the rule does not apply.
• Don’t double-deduct premiums paid from exchanged funds — they are not separately deductible.
• Don’t rush a hybrid product without comparing the total benefit pool to the lump sum committed.

Pros and Cons

• Pro — eliminates the gain tax. The annuity’s taxable gain is never taxed when spent on care, a benefit no cash-out offers.
• Pro — avoids the early-withdrawal penalty. Even under 59½, the 10% penalty on the gain is sidestepped.
• Pro — repurposes idle money. A dormant annuity becomes coverage for a likely future need.
• Pro — leverage with hybrids. A linked-benefit product can multiply your dollars into a larger care pool.
• Pro — possible inheritance. Hybrids return unused value to heirs, unlike pure-use standalone premiums.
• Con — money becomes illiquid. Funds locked into LTC use are hard to get back for other needs.
• Con — surrender charges. Exchanging early in the annuity’s life can cost real money.
• Con — “use it or lose it” on standalone policies. Premiums spent on a policy you never claim are gone.
• Con — complexity. The rules around qualification, direction, and the 180-day window are easy to fumble.
• Con — state uncertainty. Not every state mirrors the federal tax-free treatment.

What to Do Next

Take these steps in order to execute the strategy cleanly.

1. Confirm with your current carrier that the annuity is non-qualified and ask about any surrender charges.
2. Shop tax-qualified LTC products — decide between a standalone policy and a hybrid based on the decision aid above.
3. Have the new carrier prepare the 1035 exchange request form so the transfer is insurer-to-insurer.
4. If doing a partial exchange, mark the 180-day window and avoid non-annuity withdrawals during it.
5. Save the code “6” Form 1099-R when it arrives and report it on your return even though it is tax-free.
6. Check your state’s treatment with its department of revenue, and consult a CPA or tax attorney if your contract is large, partially exchanged, or possibly qualified.

This article is educational and is not a substitute for advice from a licensed professional about your specific situation. Because YMYL money decisions carry real consequences, bring in a CPA, tax attorney, or licensed insurance advisor before you move a large annuity — they will verify qualification status, model the tax, and coordinate the direct transfer so the gain stays tax-free.

FAQs

Can I do a 1035 exchange from an annuity to long-term care insurance? Yes. Since January 1, 2010, under the Pension Protection Act of 2006, you can exchange a non-qualified annuity directly into a tax-qualified LTC contract, and the gain transfers tax-free under Section 1035.

Does the 1035 exchange make the annuity gain truly tax-free, not just deferred? Yes. When the exchanged funds pay for qualified LTC benefits under Section 7702B, the gain is never taxed at all — it is eliminated, not merely postponed to a later year.

Can I use my IRA or 401(k) annuity for this strategy? No. Section 1035 applies only to non-qualified annuities. Qualified retirement money requires a rollover, and a 1035 attempt would create a fully taxable distribution.

What is the 180-day rule on a partial exchange? 180 days is the waiting period from Revenue Procedure 2011-38. After a partial exchange, you must not take a non-annuity withdrawal from either contract for 180 days, or the exchange can be voided.

What 1099-R code shows the exchange was tax-free? Code 6. It appears in Box 7 of Form 1099-R and marks a tax-free Section 1035 exchange. Box 2a, the taxable amount, should show $0.00.

Do I still report the exchange on my tax return? Yes. Even though code “6” means no tax is due, you report the Form 1099-R so the IRS sees a matching record and does not flag the unreported document.

Can I deduct LTC premiums paid from the exchanged funds? No. Premiums funded by tax-free exchanged money are not separately deductible, because that gain was already shielded from tax. Deductions apply only to premiums paid with regular after-tax dollars.

What are the 2026 deductible LTC premium limits for premiums I pay directly? $500 to $6,200, by age — $500 (40 or less), $930 (41–50), $1,860 (51–60), $4,960 (61–70), and $6,200 (over 70) for tax year 2026, counted above the 7.5% AGI floor.

Will I owe the 10% early-withdrawal penalty if I’m under 59½? No. A valid 1035 exchange is not a distribution, so the 10% penalty on the gain does not apply. The funds simply move into the new LTC contract.

Does my state tax the exchanged annuity gain? Usually no. Most income-tax states conform to the federal tax-free treatment, and nine states have no income tax. Conformity varies, so confirm with your state revenue agency.

Can I exchange a life insurance policy into LTC the same way? Yes. Section 1035 also allows a tax-free exchange of a life insurance policy into a tax-qualified LTC contract, though the cost-basis and gain rules differ from annuities.

What if my annuity still has surrender charges? You can still exchange, but the old carrier may deduct a surrender charge of several percent. Check the charge first, since it can offset or exceed the tax savings.

This article reflects federal rules as of June 2026 and covers tax years 2025 and 2026. Confirm current figures with the IRS or a licensed professional before you act.