Can a Trust-Owned Annuity Do a 1035 Exchange? (w/Examples) + FAQs

This article reflects federal rules as of June 2026 and covers tax year 2025 and the 2026 filing season. It also notes state nuances where they matter. Tax law changes — confirm current figures before you act. This is educational and not a substitute for advice from a licensed CPA, tax attorney, or estate attorney for your specific situation.

Quick Answer

Yes. A trust-owned annuity can do a 1035 exchange, tax-free, as long as the same trust owns both the old and new contract and the annuitant stays the same. The trustee must sign, the old insurer must transfer the value directly, and the trust must never take a check.

A trust that holds a non-qualified annuity is allowed to swap that contract for a better one without triggering tax, the same way an individual can. The catch is that Section 1035 demands the obligee — the owner — stay identical, so the trust that owns the first annuity must also own the second. Break that chain and the gain becomes taxable income.

The stakes are real. A botched exchange can turn years of tax-deferred growth into a single taxable event, and for a trust that growth can be taxed at the top 37% bracket above just $15,650 of income for 2025. The 65 million-plus annuity contracts in force in the U.S., per LIMRA’s 2024 sales data, include a growing share held inside trusts, so this question lands on many trustees’ desks.

Here is what you will learn:

🔁 The one ownership rule that decides whether your exchange is tax-free or taxable.
⚠️ The Section 72(u) “non-natural person” trap that can strip tax deferral from an irrevocable trust.
🧮 A fully worked example showing exactly how much tax a wrong move costs.
📝 The step-by-step paperwork — which form, who signs, and how the money must move.
🚫 The seven mistakes that turn a routine swap into a surprise tax bill.

What a 1035 Exchange Actually Is

A 1035 exchange is a tax-free swap of one insurance product for another similar one, authorized by Section 1035 of the Internal Revenue Code. Normally, when you cash out an annuity that has grown, you owe income tax on the gain. Section 1035 lets you move that built-up value into a new contract without recognizing the gain, because Congress decided a person who “merely exchanged” one contract for a better-suited one has not truly cashed out.

The rule covers specific directions only. You can exchange an annuity for another annuity, a life insurance policy for an annuity, a life policy for another life policy, and an annuity for a qualified long-term care contract. You cannot go the other way — an annuity can never become life insurance tax-free, because you would be turning taxable gain into a tax-free death benefit. The consequence of trying is a fully taxable distribution.

The reason trustees care is cost and performance. An old annuity may carry high fees, weak investment options, or a death benefit the trust no longer needs. A 1035 exchange lets the trustee upgrade to a lower-cost contract while preserving the deferred gain. A common misconception is that a 1035 exchange resets surrender charges to zero — it does not. Surrender charges live in the contract, so the trustee should confirm the old contract is past its surrender period before moving, or the trust eats a penalty. The next step is simple: pull the old contract’s surrender schedule and cost basis before you start.

The Core Rule: The Owner Must Stay the Same

The heart of every 1035 question is the “same obligee” rule in Treasury Regulation 1.1035-1. The regulation says the obligee — in plain English, the owner — under the new contract must be the same as the obligee under the old contract. For annuities, it also requires the same annuitant. If the owner changes during the swap, it is not a 1035 exchange; it is a surrender followed by a purchase, and the gain is taxed.

For a trust-owned annuity, this rule is the whole ballgame. The trust is the owner. So the trust must own both contracts. The trustee acts for the trust and signs the paperwork, but the legal owner that must match is the trust itself, identified by its name and tax ID.

The consequence of breaking the chain is steep. Say a trustee surrenders a trust annuity, the insurer cuts a check to the trust, and the trustee then buys a new annuity. That is a taxable surrender under Section 72(e), even if the trustee buys the new contract the same day. The IRS confirmed this exact trap in Revenue Ruling 2007-24, where a taxpayer who took a check and endorsed it to a new insurer lost the tax-free treatment entirely.

A common misconception is that “the trustee” must match. It is the trust that must match, not the human signing. A successor trustee can complete an exchange the prior trustee began, as long as the trust on both contracts is identical. What to do: confirm the new application lists the trust’s exact legal name and EIN as owner before anyone signs.

How Trusts Hold Annuities — and Why the Type Matters

Annuities show up inside several kinds of trusts, and the trust type controls the tax treatment that comes after the exchange. The exchange mechanics are the same, but the deferral that makes an annuity worth holding can vanish depending on the trust.

Revocable (Grantor) Trusts

A revocable living trust is the friendliest home for a non-qualified annuity. For income tax, the trust is “disregarded” — the grantor is still treated as the owner under the grantor trust rules of Sections 671–679. Because a living person stands behind the contract, the annuity keeps its tax deferral, and a 1035 exchange works cleanly. The consequence of getting this right is years of continued deferral; the consequence of ignoring it is rare here because the grantor is a natural person. What to do: simply confirm the trust still owns both contracts after the swap.

Irrevocable Trusts

Irrevocable trusts are where the danger lives. An irrevocable trust is usually a separate taxpayer with its own EIN, and it is a “non-natural person.” Under Section 72(u), an annuity owned by a non-natural person generally loses tax deferral and is taxed currently each year — unless an exception applies. The exchange itself can still be tax-free, but the new contract may not defer tax going forward. What to do: before exchanging, confirm the trust qualifies for the “agent for a natural person” exception, discussed below, or the deferral you are trying to preserve may not exist.

Special Needs and Bypass Trusts

Special needs trusts, bypass (credit-shelter) trusts, and generation-skipping trusts often hold annuities to keep assets growing without yearly tax drain. Jackson’s guidance on deferred annuities in irrevocable trusts shows these trusts can pass an annuity in kind to remainder beneficiaries, who can then run their own 1035 exchange. The consequence of mishandling a special needs trust annuity is loss of Medicaid or SSI eligibility for the beneficiary. What to do: loop in an estate attorney before any exchange that could change who is named on the contract.

The Section 72(u) Non-Natural Person Trap

This is the rule that catches trustees off guard. Section 72(u) says that if a non-natural person — a corporation, partnership, or many trusts — owns an annuity, the contract is not treated as an annuity for tax deferral. Instead, the income on the contract is taxed to the owner every year as it accrues. For a trust in the top bracket, that means tax at 37% above $15,650 of income for tax year 2025.

There is a crucial exception. The statute says a trust holding an annuity “as an agent for a natural person” keeps the deferral. In practice, the IRS has treated annuities held by a trust for the benefit of natural-person beneficiaries as qualifying, while a trust benefiting a non-natural beneficiary — like a charity or an entity — does not. The consequence of missing this is brutal: the trust loses deferral retroactively and owes back tax plus interest on income it never distributed.

A real-world example shows the danger. Suppose the Reyes Family Irrevocable Trust names a charity as a beneficiary alongside two grandchildren. Because a charity is not a natural person, the IRS may treat the entire annuity as failing the agent-for-a-natural-person test, taxing all the growth annually. A common misconception is that naming even one non-natural beneficiary is harmless — it can poison the whole contract’s deferral. What to do: review the trust’s beneficiary list against the 72(u) exception before funding or exchanging an annuity, and get a tax opinion if any beneficiary is an entity.

Which Situation Applies to You?

The right path depends on the kind of trust and what you are trying to fix. Find your row, then read the section it points to.

You hold a revocable living trust annuity and want a cheaper contract — a clean 1035 exchange almost always works; read “The Core Rule” and “Step-by-Step.”
You hold an irrevocable trust annuity and worry about yearly tax — read “The Section 72(u) Trap” first; the exchange may be fine but the deferral may not exist.
You are settling an estate and the trust is winding down — read “Passing an Annuity In Kind”; you may not need an exchange at all.
A beneficiary inherited a trust-owned annuity — read the FAQ on beneficiary exchanges; limited 1035 swaps are allowed for inherited contracts.
The trust annuity is a qualified/IRA annuity — a 1035 exchange does not apply; you use a trustee-to-trustee transfer or rollover instead.

Step-by-Step: How a Trustee Completes a 1035 Exchange

A trust-owned 1035 exchange is paperwork-driven, and each step has a consequence if skipped.

Confirm ownership and basis. Pull the old contract and verify the trust is the owner. Record the cost basis and any gain. Skipping this means you cannot tell whether the exchange even helps.
Choose the new contract and confirm matching ownership. The new annuity application must name the same trust as owner and the same annuitant. A mismatch here is the single most common way to blow the exchange.
Complete the insurer’s 1035 exchange form. Each carrier has its own absolute-assignment form, like the John Hancock 1035 exchange form. The trustee signs in a fiduciary capacity, often “as Trustee of the [Trust Name].”
Require a direct insurer-to-insurer transfer. The money must move directly between companies. If the trust receives a check, Rev. Rul. 2007-24 makes the proceeds taxable.
Verify the carrier reports it correctly. The old insurer should issue a Form 1099-R coded “6” for a 1035 exchange, signaling a tax-free transfer. A wrong code triggers an IRS notice the trust must then fight.
Keep records. Retain the assignment form, the 1099-R, and proof of direct transfer in the trust file. Missing records make an audit far harder.

There is no IRS form you file to elect a 1035 exchange — the carriers report it. The process usually takes two to six weeks. DIY through the carrier costs nothing, but a one-hour review by a tax attorney for a complex irrevocable trust typically runs $300 to $800, cheap insurance against a five-figure tax mistake.

Worked Example: The Cost of Doing It Wrong

Numbers make the risk concrete. Assume the Carter Bypass Trust owns a non-qualified annuity worth $400,000 with a cost basis of $150,000. The gain is $250,000. The trustee wants to move to a lower-cost contract.

Path A — Proper 1035 exchange. The trustee files the carrier’s assignment form, the trust stays the owner, and the money transfers directly from Insurer 1 to Insurer 2. The Form 1099-R is coded “6.” The trust recognizes $0 of income. The full $400,000 keeps growing tax-deferred.

Path B — Surrender then repurchase. The trustee surrenders the contract, the trust receives a $400,000 check, and the trustee buys a new annuity the next week. Under Section 72(e), the $250,000 gain is ordinary income to the trust this year. Because trusts hit the top 37% rate above $15,650 for 2025, nearly all of that gain is taxed at 37%.

Here is the math on Path B. The first $15,650 and the bracket steps below the top are taxed at lower rates, but the bulk falls in the 37% bracket. Roughly $234,000 of the gain is taxed at 37%, costing about $86,580, plus lower-bracket tax of about $3,900 on the first portion, plus the 3.8% Net Investment Income Tax on the gain above the trust threshold, adding roughly $8,900. The total tax bill lands near $99,000 — money the trust never had to pay had the trustee used a direct transfer.

Three Common Trust-Owned Annuity Scenarios

These scenarios cover the situations trustees face most often.

Scenario 1: Revocable Trust Upgrading a High-Fee Annuity

Trustee Move	Tax Result
Trust owns both contracts; direct carrier-to-carrier transfer	Tax-free under Section 1035; deferral continues
Annuitant stays the same; only the contract changes	Exchange qualifies; no gain recognized
Trust takes a check first, then buys new contract	Entire gain taxed as ordinary income

Scenario 2: Irrevocable Trust With an Entity Beneficiary

Trustee Move	Tax Result
Trust holds annuity only for natural-person beneficiaries	Deferral preserved; 1035 exchange tax-free
Trust names a charity or LLC among beneficiaries	Section 72(u) may strip deferral; income taxed yearly
Trustee exchanges without a 72(u) review	Exchange tax-free, but ongoing deferral may not exist

Scenario 3: Estate Settlement and In-Kind Transfer

Trustee Move	Tax Result
Annuity passes in kind to remainder beneficiaries	No taxable event; ownership transfers per trust terms
Beneficiary then runs a 1035 exchange into a new annuity	Allowed; new owner matches old for the beneficiary’s contract
Trustee surrenders annuity to split cash among heirs	Gain taxed to the trust or beneficiaries

Passing an Annuity In Kind vs. Exchanging It

Sometimes the trustee does not need a 1035 exchange at all. When an irrevocable trust is designed to distribute assets to remainder beneficiaries, Jackson’s trust annuity guidance explains that an annuity can pass in kind to those beneficiaries without a taxable event, if the contract was titled correctly from the start. Each beneficiary then becomes the owner and can choose to keep the contract, exchange it, or liquidate it.

This matters because a 1035 exchange and an in-kind distribution solve different problems. An exchange upgrades a contract the trust keeps; an in-kind transfer moves the contract out of the trust to a person. A common misconception is that distributing an annuity from a trust is always taxable. With correct titling, it can pass without tax and even let the new owner run their own 1035 exchange — for example, swapping into a contract with lifetime income. What to do: ask whether the trust is meant to hold the annuity long-term or distribute it, then choose the matching tool.

Federal vs. State Treatment

Federal law sets the 1035 rules, but states add their own wrinkles. The federal rule is uniform nationwide: a qualifying 1035 exchange triggers no federal income tax, and the same-owner rule applies in every state.

States generally follow the federal tax-free treatment for income tax, since most conform to the federal definition of taxable income. The bigger state issue is the state premium tax some states levy on annuity contracts, and whether a 1035 exchange triggers it. A handful of states — including parts of the annuity market in California, Nevada, and a few others — impose premium taxes that can apply at issuance. The consequence of ignoring this is a small but real cost on the new contract. What to do: ask the new carrier whether your state charges a premium tax on the incoming contract before you sign.

Issue	Federal Rule	State Variation
Income tax on a valid 1035 exchange	No tax recognized	Most states conform and impose none
Premium tax on the new annuity	Not a federal concept	A few states charge it at issuance
Section 72(u) deferral loss	Federal income tax yearly	Flows through to most state returns

Mistakes to Avoid

Each of these errors carries a specific, avoidable cost.

Letting the trust take a check. Under Rev. Rul. 2007-24, receiving proceeds first makes the whole gain taxable, even if you rebuy immediately.
Changing the owner during the swap. A new owner breaks the same-obligee rule, converting a tax-free exchange into a taxable surrender.
Changing the annuitant. For annuities, the annuitant must match; a switch can disqualify the exchange.
Ignoring Section 72(u) in an irrevocable trust. You may complete the exchange yet still owe yearly tax because deferral was already lost.
Naming an entity beneficiary without review. A charity or LLC beneficiary can void the natural-person exception and strip deferral.
Exchanging while surrender charges still apply. A 1035 exchange does not waive the old contract’s surrender penalty, costing the trust real dollars.
Trying to exchange an annuity into life insurance. That direction is not allowed under Section 1035 and produces a fully taxable event.
Failing to confirm the 1099-R code. A miscoded Form 1099-R makes the IRS treat a tax-free swap as taxable until you prove otherwise.

Do’s and Don’ts

Do’s

Do confirm the trust owns both contracts — because the same-obligee rule is the whole test.
Do require a direct carrier-to-carrier transfer — because any check to the trust triggers tax.
Do review Section 72(u) before an irrevocable trust exchange — because deferral may already be gone.
Do keep the assignment form and 1099-R — because audits demand proof the transfer was direct.
Do check the old contract’s surrender period — because the exchange does not waive penalties.

Don’ts

Don’t change the owner or annuitant mid-exchange — because that breaks 1035 entirely.
Don’t assume the trustee must match — because it is the trust, not the person, that must stay the same.
Don’t exchange an annuity for life insurance — because the code forbids that direction.
Don’t name an entity beneficiary without a tax opinion — because it can poison deferral for everyone.
Don’t rely on the agent to track basis — because the trustee owns the recordkeeping duty.

Pros and Cons of a Trust-Owned 1035 Exchange

Pros

Preserves tax deferral — because the gain rolls into the new contract untaxed.
Lowers ongoing fees — because the trustee can move to a cheaper, modern contract.
Improves investment options — because newer annuities offer better sub-accounts.
Fulfills fiduciary duty — because trustees must prudently manage trust assets.
No IRS form to file — because carriers report the exchange for you.

Cons

Resets surrender charges if mistimed — because penalties follow the contract.
Section 72(u) risk in irrevocable trusts — because deferral can be lost regardless.
Possible state premium tax — because a few states charge it on the new contract.
Complex paperwork — because one titling error voids the tax break.
Loss of favorable old contract features — because rich death benefits or rates rarely transfer.

What to Do Next

Take these steps in order before initiating any trust-owned annuity exchange.

Gather the documents — the old annuity contract, its cost basis, the surrender schedule, and the trust agreement.
Confirm the owner and annuitant that must appear on the new contract; they must match the old one exactly.
Run the Section 72(u) check if the trust is irrevocable, focusing on whether every beneficiary is a natural person.
Request a direct transfer in writing and complete the carrier’s assignment form, never accepting a check.
Call a professional — a tax attorney or CPA — when the trust is irrevocable, has an entity beneficiary, or holds more than $250,000 of gain. A review here costs far less than a wrong move.

FAQs

Can a revocable trust do a 1035 exchange on an annuity?

Yes. A revocable living trust is treated as a grantor trust, so the annuity keeps its deferral and the exchange is tax-free, as long as the same trust owns both contracts and the annuitant stays the same.

Can an irrevocable trust do a 1035 exchange?

Yes. The exchange itself can be tax-free, but Section 72(u) may strip ongoing deferral because the trust is a non-natural person. Confirm the agent-for-a-natural-person exception first.

Does the trustee’s name have to match on both contracts?

No. The trust must match, not the individual trustee. A successor trustee can complete an exchange the trust began, since the trust is the legal owner that must stay the same.

What happens if the trust takes a check before buying the new annuity?

The gain becomes taxable. Rev. Rul. 2007-24 holds that receiving and re-endorsing a check is a taxable surrender, not a 1035 exchange, even if you rebuy the same day.

Can a trust exchange an annuity for life insurance?

No. Section 1035 only allows life-to-annuity, not annuity-to-life. Trying it produces a fully taxable distribution of the annuity’s gain.

Is there an IRS form to file for a 1035 exchange?

No taxpayer form. The carriers handle reporting; the old insurer issues a Form 1099-R coded “6” to signal a tax-free exchange. Keep it in the trust file.

Does a 1035 exchange waive surrender charges?

No. Surrender charges belong to the contract, not the tax rule. The trust still pays any penalty if it exchanges during the surrender period.

Can a beneficiary who inherited a trust-owned annuity do a 1035 exchange?

Yes, in limited cases. The IRS has allowed beneficiaries of non-qualified annuities to exchange into another beneficiary annuity, as long as the post-death payout schedule is preserved.

Does my state tax a 1035 exchange?

Usually no income tax. Most states conform to the federal tax-free rule. A few states impose a premium tax on the new annuity at issuance, so confirm with the carrier.

What tax year figures apply to trust income from a failed exchange?

Tax year 2025 figures. A trust reaches the top 37% bracket above $15,650 of income, plus the 3.8% Net Investment Income Tax, so a failed exchange is taxed heavily.

Can a qualified or IRA annuity in a trust use a 1035 exchange?

No. Section 1035 covers non-qualified contracts. Qualified annuities use trustee-to-trustee transfers or rollovers instead, under different IRS rules.

Who should I call before exchanging a trust annuity?

A tax attorney or CPA. This is essential for irrevocable trusts, entity beneficiaries, or large gains, where a single titling or 72(u) error can cost tens of thousands.

Related reading