Can You 1035 Exchange an Endowment Into an Annuity? (w/Examples) + FAQs

This article reflects federal rules and general state rules as of June 2026 and covers tax year 2025 and the 2026 filing season. Tax law changes — confirm current figures before you file.

Quick Answer

Yes. Under Internal Revenue Code Section 1035, you can exchange an endowment contract for an annuity contract with no gain or loss recognized today. The transfer must move directly between insurers, keep the same insured, and avoid any cash hitting your hands.

This matters because an endowment that matures or no longer fits your goals can carry a large built-in gain, and cashing it out triggers ordinary income tax on every dollar of growth. A properly handled 1035 exchange into an annuity moves that whole value — basis and gain — into the new contract untaxed, so your money keeps compounding instead of shrinking at tax time.

The stakes are real and time-sensitive. The wrong move — taking a check, naming a new owner, or letting the old insurer mail you the proceeds — can turn a tax-free swap into a fully taxable event in one filing year. The IRS reports that pensions and annuities make up one of the largest income categories on individual returns, so the rules around moving these contracts touch millions of taxpayers.

Here is what you will learn:

🔁 The exact rule in Section 1035 that lets an endowment flow into an annuity tax-free
🧮 A fully worked example showing the dollars saved versus a cash-out
⏱️ The “regular payments” timing trap that can disqualify your exchange
📄 How the swap shows up on Form 1099-R with distribution code 6
🚫 The seven mistakes that turn a tax-free exchange into a taxable surrender

What a 1035 Exchange Actually Is

A 1035 exchange is a tax-free swap of one insurance-based contract for another similar contract. The rule lives in Section 1035 of the tax code, and its core promise is simple: “no gain or loss shall be recognized on the exchange.” That means you do not pay income tax at the moment of the swap, even if the old contract grew far beyond what you paid in.

The purpose is to let people upgrade or change financial products without a tax penalty for doing so. Congress reasoned that if you are simply moving the same pool of insurance money from one contract to a comparable one, you have not truly “cashed out” — so there is nothing to tax yet. The tax does not vanish; it is deferred. Your old cost basis carries over to the new contract under the basis rules in Section 1031(d), so the gain is taxed later when you eventually take money out as income.

The consequence of misunderstanding this is steep. People often think a 1035 exchange erases the tax. It does not. It only postpones it. When you later draw income from the annuity, the growth comes out as ordinary income, taxed at your regular rate — not the lower long-term capital gains rate. Knowing this up front helps you plan the withdrawal side, not just the swap.

A common misconception is that any insurance product can be swapped for any other tax-free. That is false, and the direction of the swap is everything. The next sections show exactly which directions the law allows.

The Three Core Pieces: Endowment, Annuity, and the Exchange Rule

To use this rule correctly, you need to know what each contract is and how the law defines it. These definitions are not marketing terms — they come straight from the statute.

What Is an Endowment Contract?

An endowment contract is a hybrid insurance policy. Section 1035(b)(1) defines it as a contract with an insurance company that “depends in part on the life expectancy of the insured, but which may be payable in full in a single payment during his life.” In plain words, it pays a death benefit if you die early, but it also “endows” — pays out a lump sum — on a set maturity date if you are still alive.

These were popular decades ago as forced-savings vehicles, often timed to mature at retirement, a child’s college age, or a mortgage payoff. Today they are largely a legacy product in the United States, so most people reading this already own one — often an older policy inherited from a parent’s planning or bought years ago. The consequence of a maturing endowment is a taxable event: when it pays out in cash, the growth above your basis is taxed as ordinary income that year.

A frequent misconception is that an endowment is “just life insurance.” It is not. Because it can pay in full during your life, it is treated as its own category, and that category has special exchange limits — including the timing rule covered below. What you should do: locate your contract’s maturity date and current cash value before it endows, because that date starts your decision clock.

What Is an Annuity Contract?

An annuity contract is defined in Section 1035(b)(2) as a contract that “may be payable during the life of the annuitant only in installments.” Unlike an endowment, an annuity is built to pay you a stream of income — monthly, quarterly, or yearly — often for life. It is the classic tool for turning a lump sum into a paycheck you cannot outlive.

Annuities grow tax-deferred, so moving endowment money into one keeps the tax shelter intact. The consequence of choosing an annuity is that you trade a one-time lump sum for income flexibility, but you also accept that future withdrawals are taxed as ordinary income and that early withdrawals before age 59½ can trigger a 10% federal penalty under Section 72(q).

People often assume all annuities are the same. They are not — immediate, deferred, fixed, indexed, and variable annuities behave very differently. What you should do: match the annuity type to your goal (lifetime income versus continued growth) before you sign the exchange paperwork, because the choice is hard to undo.

What the Exchange Rule Permits

Treasury Regulation 1.1035-1 spells out which swaps qualify. An endowment contract can be exchanged tax-free for “another contract of endowment insurance… or an annuity contract.” So endowment-to-annuity is squarely allowed. The exchange must also keep the same insured — you cannot use it to change who the policy covers.

The consequence of getting the direction wrong is full taxation. The regulation states plainly that an annuity-for-endowment swap, or any endowment-or-annuity-for-life-insurance swap, does not qualify, and “any gain or loss shall be recognized.” What you should do: confirm your target product is a true annuity, not a repackaged life-insurance or endowment policy, before transferring a dime.

Which Direction Is Allowed? (The Acceptable Swap Chart)

The single most important rule is direction. The law lets you move “down” the chain toward annuities, but never “up” toward life insurance. Think of it as a one-way valve.

The allowed and disallowed swaps under Section 1035(a) and its regulation are:

Proposed Swap	Tax Result
Endowment → Annuity	Tax-free under Section 1035(a)(2)
Endowment → another Endowment (payments start no later)	Tax-free, with a timing condition
Endowment → Qualified long-term care contract	Tax-free under Section 1035(a)(2)(C)
Life insurance → Endowment or Annuity	Tax-free under Section 1035(a)(1)
Annuity → Annuity (same obligee)	Tax-free under Section 1035(a)(3)
Annuity → Endowment	Taxable — not permitted
Endowment or Annuity → Life insurance	Taxable — not permitted

The logic is that life insurance gets the most generous tax treatment (a tax-free death benefit), so Congress will not let you swap a less-favored contract into it without paying tax first. The consequence of trying is a fully taxable surrender of your old contract.

The Endowment Timing Trap (Section 1035(a)(2))

Endowments carry a unique restriction that annuities and life policies do not. This trap catches people who swap one endowment for another, and you must understand it even when your goal is an annuity.

Under Section 1035(a)(2)(A), an endowment-for-endowment exchange only stays tax-free if the new endowment “provides for regular payments beginning at a date not later than the date payments would have begun under the contract exchanged.” In plain words, you cannot use a 1035 exchange to push back your maturity date. The IRS does not want you using the swap to extend tax deferral on an endowment past its original payout date.

Here is the relief: this timing condition applies to endowment-to-endowment swaps. When you exchange an endowment for an annuity — under Section 1035(a)(2)(B) — the “regular payments” date restriction does not bind the same way, because an annuity is a different contract type with its own payout structure. This is exactly why moving a maturing endowment into a deferred annuity is often cleaner than moving it into a new endowment.

The consequence of ignoring this is disqualification. If you try to roll an endowment into a new endowment that pushes the payout date later, the IRS treats the whole thing as a taxable surrender, and your gain becomes ordinary income that year. What you should do: if you want to keep deferring growth past your endowment’s maturity date, exchange into an annuity, not a later-maturing endowment.

Which Situation Applies to You?

The right path depends on where you stand with your endowment right now. Find your situation below and follow it.

Your endowment is about to mature and you want to avoid the lump-sum tax hit. Exchange into a deferred or immediate annuity before the maturity date pays out in cash. Once the insurer issues the check, it is too late.
Your endowment already matured and you received a check. The tax-free window is likely closed — receiving the proceeds is “constructive receipt,” and a later annuity purchase does not undo the tax. Talk to a CPA fast.
You want lifetime income now. Exchange into an immediate annuity so payments start within a year.
You want continued tax-deferred growth. Exchange into a deferred annuity and choose your income start date later.
You want long-term care coverage instead. Section 1035(a)(2)(C) lets you exchange an endowment into a qualified long-term care contract tax-free.
You have an outstanding policy loan on the endowment. That loan can create taxable “boot” — see the boot section before you move.

A Fully Worked Example: The Dollars Saved

Numbers make this real. Here is the math the IRS website will not hand you, step by step, so you can copy it for your own contract. All figures use tax year 2025 rates for illustration.

Assume Maria owns an endowment contract maturing in 2025 with these figures:

Current cash value: $120,000
Total premiums paid (cost basis): $70,000
Built-in gain: $120,000 − $70,000 = $50,000

Path A — Cash out the endowment. Maria surrenders the contract and takes the $120,000. The $50,000 gain is taxed as ordinary income. If she sits in the 24% federal bracket for 2025, her tax is:

$50,000 × 24% = $12,000 federal tax
Net kept: $120,000 − $12,000 = $108,000

Path B — 1035 exchange into a deferred annuity. Maria moves the full $120,000 directly to a new annuity insurer. No gain is recognized in 2025, so her tax that year is $0. Her $70,000 basis carries over to the annuity. All $120,000 keeps compounding.

The difference. Path B keeps an extra $12,000 working for her in year one. If that $12,000 of avoided tax stays invested at 5% for 10 years, it grows to roughly $19,500 — money she would never have had if she cashed out. The tax is not gone; she will pay ordinary income tax on growth as she draws annuity income later, but she controls the timing and may be in a lower bracket in retirement.

How the Exchange Shows Up on Your Taxes

Even though a 1035 exchange is tax-free, it is not invisible. The insurer reports it, and you must handle it correctly on your return.

The old insurer issues you a Form 1099-R for the year of the exchange. The key is Box 7, the distribution code. A proper 1035 exchange carries code 6, which the IRS instructions define as a “Section 1035 exchange.” Code 6 tells the IRS the transfer is a tax-free exchange, not a taxable distribution.

The consequence of a wrong or missing code is an IRS notice. If the 1099-R shows a taxable code (like 1 or 7) and a taxable amount in Box 2a, the IRS computer expects tax — and you may get a CP2000 notice demanding payment. What you should do: when the 1099-R arrives, check that Box 7 reads code 6 and Box 2a (taxable amount) shows $0; if it is wrong, ask the insurer for a corrected form before you file. You still report the 1099-R on your return even though the taxable amount is zero.

The Boot Problem: When Part of It Gets Taxed

A clean 1035 exchange moves only contract-for-contract value. The moment cash or other property enters the deal, you can create “boot” — and boot is taxable.

“Boot” means money or other non-like property you receive in the swap. Section 1035(d) points to the rules in Section 1031(b) and (c), which say gain is recognized up to the amount of boot received. So if you pull out $10,000 in cash during the exchange and your contract has a $50,000 gain, that $10,000 becomes taxable ordinary income.

A common boot trap is an outstanding policy loan. If your endowment has a $15,000 loan and the new annuity does not carry it over, the forgiven loan is treated like cash you received — taxable boot. The consequence is an unexpected tax bill on a swap you thought was fully tax-free. What you should do: pay off or carefully transfer any policy loan before the exchange, and never request cash “on the side” during the transfer.

Step-by-Step: How to Do the Exchange

The process is paperwork-driven, and the order matters. Follow these steps.

Confirm your contract is an endowment and locate its cash value, cost basis, and maturity date.
Choose the receiving annuity and its insurer, matching the type to your goal (immediate for income now, deferred for growth).
Request the insurer’s 1035 exchange form — the new (receiving) insurer initiates a direct insurer-to-insurer transfer. Do not surrender the old contract yourself.
Sign an absolute assignment so the old insurer sends funds directly to the new insurer. You never touch the money.
Resolve any policy loan before transfer to avoid taxable boot.
Confirm the same insured carries over — the exchange fails if the insured changes.
Keep the basis records — your original premiums paid carry into the new contract and matter for future withdrawal taxation.
Verify the Form 1099-R shows code 6 with a $0 taxable amount the following January.

The deadline is practical, not statutory: complete the exchange before your endowment matures and pays out in cash. Once the lump sum is in your hands, the tax-free window is gone. A direct transfer typically takes two to six weeks. DIY costs little beyond possible surrender charges; a fee-only advisor or CPA review for a complex case runs roughly $200–$500 an hour, which is worth it when a policy loan, large gain, or maturity deadline is involved.

Three Common Scenarios

These three patterns cover most endowment-to-annuity decisions.

Scenario 1 — The Clean Pre-Maturity Swap

What James Does	What Happens
Owns a $90,000 endowment ($60,000 basis) maturing next year	$30,000 built-in gain sits untaxed
Requests a direct 1035 exchange into a deferred annuity before maturity	No gain recognized; $0 tax this year
Receives a 1099-R with code 6, Box 2a $0	IRS treats it as tax-free; basis carries over

James avoids a $7,200 tax bill (24% of $30,000) and keeps his full balance compounding.

Scenario 2 — The Accidental Cash-Out

What Linda Does	What Happens
Lets her $150,000 endowment mature and mails herself the check	Constructive receipt — the gain is locked in
Buys an annuity two weeks later with the cash	Too late; no 1035 protection on a post-receipt purchase
Reports the surrender on her return	$80,000 gain taxed as ordinary income

Linda’s late annuity purchase does not undo the tax. Timing destroyed her exchange.

Scenario 3 — The Policy-Loan Boot Trap

What David Does	What Happens
Exchanges an endowment with a $20,000 outstanding loan	The unrepaid loan counts as boot
New annuity does not carry the loan	$20,000 treated as cash received
Has a $35,000 gain in the contract	$20,000 of gain is taxed; the rest stays deferred

David could have avoided the bill by repaying the loan before the swap.

Three Named Examples in Action

Patricia, age 64, wants lifetime income. Her endowment matures this year with $200,000 of value and $130,000 of basis. She does a direct 1035 exchange into an immediate annuity. No tax is due on the $70,000 gain at the swap. Her monthly payments are partly tax-free return of basis and partly taxable gain, spread over her life expectancy under the exclusion ratio rules.

Robert, age 52, wants more growth. Robert exchanges his $85,000 endowment into a deferred fixed annuity. Because he is under 59½, he plans no withdrawals yet — taking money now would risk the 10% early-withdrawal penalty under Section 72(q). His exchange is tax-free, and his $55,000 basis carries forward.

Susan inherits her father’s matured endowment. The contract already endowed and paid out before Susan could act, so there is no contract left to exchange. The gain was taxed on her father’s final return. Susan learns the lesson: a 1035 exchange must happen while a live contract still exists, not after it pays out.

Federal vs. State: Does Your State Follow Section 1035?

Section 1035 is a federal income tax rule. The first question — “Is the exchange tax-free for federal income tax?” — is answered by the federal statute, and the answer for endowment-to-annuity is yes.

The second question — “Does my state tax it?” — usually follows the federal answer, but not always in the same way. Most states with an income tax start from federal adjusted gross income or federal taxable income, so a transaction that is tax-free federally is generally tax-free at the state level too. States with no income tax — such as Texas, Florida, Nevada, Washington, South Dakota, Wyoming, and Alaska — do not tax the exchange or the later annuity income at all, which is a complete answer for residents there.

The consequence of assuming perfect conformity is a surprise. A handful of states use their own definitions or decouple from specific federal provisions, and some impose a small insurance premium tax when annuity premiums are paid — a separate charge from income tax. What you should do: confirm your state starts from federal income and check whether your state levies a premium tax on annuity contracts, because that cost is separate from the federal 1035 result. When in doubt, ask a CPA licensed in your state.

Mistakes to Avoid

Each of these errors carries a real cost.

Taking a check from the old insurer. This is constructive receipt, and it makes the entire gain taxable as ordinary income that year.
Swapping in the wrong direction. Moving an annuity into an endowment, or any contract into life insurance, is fully taxable under the regulation.
Changing the insured during the swap. The exchange must keep the same insured; changing it voids the tax-free treatment.
Ignoring a policy loan. An unrepaid loan becomes taxable boot, creating a bill on money you never “received” in cash.
Pushing an endowment’s payout date later via a new endowment. This breaks the Section 1035(a)(2)(A) timing rule and disqualifies the exchange.
Filing without checking Box 7. A wrong distribution code (not code 6) can trigger a CP2000 notice demanding tax on a tax-free swap.
Forgetting your carryover basis. Losing track of your original premiums means overpaying tax later when you withdraw annuity income.
Overlooking surrender charges. The IRS does not waive the old insurer’s surrender fees just because the swap is tax-free.

Do’s and Don’ts

Do:

Do use a direct insurer-to-insurer transfer, because it preserves the tax-free treatment.
Do confirm the receiving product is a true annuity, because the contract type controls the tax result.
Do resolve loans before the exchange, because unpaid loans create taxable boot.
Do keep your basis records, because they reduce the tax on future annuity income.
Do act before the endowment matures, because cash in hand closes the window.

Don’t:

Don’t accept a check and re-deposit it, because that is a taxable surrender, not an exchange.
Don’t swap into life insurance, because the law taxes that direction in full.
Don’t assume the tax disappears, because it is deferred, not erased.
Don’t ignore the 10% penalty, because withdrawals before 59½ from the new annuity can be penalized.
Don’t skip the 1099-R review, because an uncorrected wrong code creates an IRS notice.

Pros and Cons of Exchanging an Endowment Into an Annuity

Pros:

Tax deferral continues, because no gain is recognized at the swap.
Income flexibility, because an annuity can pay a lifetime stream you cannot outlive.
Basis carries over, because your original premiums keep their tax value.
Avoids a maturity-year tax spike, because you skip the lump-sum income hit.
Long-term care option exists, because an endowment can also swap into a qualified LTC contract tax-free.

Cons:

Tax is only postponed, because future withdrawals are ordinary income.
Surrender charges may apply, because the old insurer’s fees are not waived.
Early-withdrawal penalty risk, because taking money before 59½ can cost 10%.
Loss of lump-sum access, because annuitized income limits liquidity.
Product complexity, because variable and indexed annuities carry fees and risk.

What to Do Next

Take these steps in order, starting today.

Pull your endowment contract and write down the cash value, total premiums paid (basis), and maturity date.
Decide your goal — income now (immediate annuity) or growth (deferred annuity).
Resolve any policy loan before you start, to avoid taxable boot.
Contact the receiving annuity insurer and request its 1035 exchange/absolute-assignment form so the transfer goes insurer-to-insurer.
Never accept the funds yourself — the money must move directly.
In January, verify your Form 1099-R shows code 6 and a $0 taxable amount, and report it on your return.
Call a CPA or tax attorney if you have a large gain, a policy loan, a state conformity question, or a maturity deadline closing in.

This article is educational and is not a substitute for advice from a licensed tax professional for your specific situation. A complex case — a sizable gain, an outstanding loan, an estate involved, or an uncertain state rule — is worth a paid review by a CPA or tax attorney, which typically involves confirming the swap qualifies, checking your basis, and verifying the 1099-R coding.

Frequently Asked Questions

Can you 1035 exchange an endowment into an annuity?

Yes. Section 1035(a)(2)(B) allows an endowment contract to be exchanged for an annuity contract with no gain recognized, as long as the transfer is direct and the same insured is kept. The tax is deferred, not erased.

Is a 1035 exchange completely tax-free forever?

No. It defers tax, it does not eliminate it. The gain becomes ordinary income later when you withdraw from the annuity, taxed at your regular rate rather than capital gains rates.

Can you exchange an annuity back into an endowment?

No. Treasury Regulation 1.1035-1 specifically disallows an annuity-for-endowment exchange. Any gain on that transaction is fully recognized and taxed in the year of the swap.

What distribution code appears on Form 1099-R for a 1035 exchange?

Code 6. The IRS uses Box 7 code 6 to flag a Section 1035 exchange. Box 2a, the taxable amount, should read $0. You still report the form on your return.

Does the same insured have to stay on the contract?

Yes. The exchange only qualifies if the new contract relates to the same insured. Changing the insured voids the tax-free treatment and triggers a taxable surrender.

What is “boot” in a 1035 exchange?

Boot is cash or other property you receive in the swap. Under Section 1031(b)-(c), gain is taxed up to the amount of boot. An unpaid policy loan often counts as taxable boot.

Will I owe a penalty if I exchange before age 59½?

No, not on the exchange itself. The swap is penalty-free. But withdrawing money from the new annuity before 59½ can trigger a 10% federal early-withdrawal penalty under Section 72(q).

How long does a 1035 exchange take?

About two to six weeks. The receiving insurer initiates a direct transfer, and timing depends on both companies. Start before your endowment matures to keep the swap tax-free.

Can I exchange an endowment into a long-term care policy instead?

Yes. Section 1035(a)(2)(C) permits a tax-free exchange of an endowment into a qualified long-term care insurance contract, the same way it permits an exchange into an annuity.

Does my state tax a 1035 exchange?

Usually not for income tax. Most income-tax states follow the federal result and treat the exchange as tax-free, and no-income-tax states do not tax it at all. Some states impose a separate premium tax on annuities.

What happens if my endowment already matured and paid me?

The window is likely closed. Once you receive the proceeds, it is constructive receipt and the gain is taxable. Buying an annuity afterward does not restore Section 1035 protection.

Does cashing out instead of exchanging ever make sense?

Sometimes. If your gain is small, you are in a low bracket, or you need the cash now, paying the tax and taking the lump sum can beat locking funds into an annuity. Weigh liquidity against deferral.

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