Can You 1035 Exchange One Annuity for Another? (w/Examples) + FAQs

This article reflects federal rules as of June 2026 and covers tax year 2025 and the 2026 filing season. State income-tax treatment varies, so a general state note is included. Tax law changes — confirm current figures with the IRS or a licensed professional before you act.

Quick Answer

Yes. For tax year 2025, you can swap one annuity for another tax-free under Internal Revenue Code Section 1035. No gain is taxed if the insurer moves the money directly, the owner stays the same, and you trade an annuity only for another annuity or a qualified long-term care contract.

A 1035 exchange lets you move out of an annuity that no longer fits — one with high fees, a weak income rider, or a struggling insurer — and into a better contract without triggering a tax bill on your gains. The catch is that the transfer must be a true insurer-to-insurer move; if you take a check first, the IRS treats the whole gain as taxable income that same year.

The stakes are real. A deferred annuity can hold years of tax-deferred growth, and surrendering it the wrong way can convert that growth into ordinary income taxed at rates up to 37% for 2025. According to the Secure Retirement Institute, U.S. annuity sales hit a record $432.4 billion in 2024, so millions of contracts are now in force and many owners are weighing whether to switch.

Here is what you will learn:

🔄 How a 1035 exchange works step by step, and the exact rules that keep it tax-free.
🧮 A fully worked example showing how your cost basis carries over to the new contract.
✂️ How a partial 1035 exchange works and the 180-day rule that can blow it up.
🏦 Why qualified (IRA) annuities use a rollover, not a 1035, and why mixing them up is costly.
⚠️ The seven mistakes that turn a tax-free swap into a surprise tax bill.

What a 1035 Exchange Actually Is

A 1035 exchange is a tax-free trade of one insurance or annuity contract for another, named after Section 1035 of the tax code. The law exists so that people who “merely exchanged one insurance policy for another better suited to their needs” do not owe tax simply for upgrading, as the legislative history of the statute explains. Without it, leaving an old annuity would force you to surrender the contract, take the cash, and pay income tax on every dollar of gain.

The key idea is nonrecognition. Nonrecognition means the gain still exists, but the IRS does not tax it now — it rides along inside the new contract until you eventually withdraw or annuitize. You are not erasing the tax; you are postponing it and keeping your tax-deferred status intact.

Section 1035 covers only specific swaps. For an annuity owner, the allowed moves are an annuity for another annuity and an annuity for a qualified long-term care insurance contract, a category Congress added through the Pension Protection Act effective for exchanges after 2009. The consequence of stepping outside these lanes is severe: the transaction loses tax-free status and the gain becomes taxable.

The most important limit is direction. You can move from life insurance down to an annuity, but you can never go from an annuity up to a life insurance policy. The reason is that life insurance carries a tax-free death benefit, and the law will not let you launder taxable annuity gains into a tax-free life payout. If you try, the IRS treats the move as a full surrender and taxes the gain.

What should you do about it? Before you sign anything, confirm in writing that both contracts are annuities (or that the receiving contract is a qualified long-term care policy) and that the carrier will process it as a 1035 exchange — not a surrender and repurchase.

The Three Rules That Keep It Tax-Free

A 1035 annuity-to-annuity exchange survives IRS review only when three conditions are met. Miss any one and the swap collapses into a taxable distribution under Section 72(e).

Rule 1 — Same Owner, Same Annuitant

The person who owns the old contract must own the new one. Treasury Regulation 1.1035-1 limits tax-free annuity swaps to cases where “the same person or persons are the obligee or obligees” on both contracts. If you try to change the owner — say, to move your annuity into your spouse’s name — the IRS sees a gift or a sale, not an exchange. The fix is simple: keep the ownership identical, and handle any ownership change as a separate step, ideally with a tax advisor first.

Rule 2 — A Direct Insurer-to-Insurer Transfer

You cannot touch the money. The old carrier must send the funds straight to the new carrier. In Revenue Ruling 2007-24, the IRS ruled that when a taxpayer received a check and endorsed it to a second company, the move was a taxable distribution under Section 72(e), not a tax-free 1035 exchange. The consequence is that all gain becomes ordinary income that year. To stay safe, sign the new insurer’s 1035 transfer paperwork and let the companies move the money directly.

Rule 3 — Annuity to Annuity (or Qualified LTC)

The contract you receive must be an annuity or a qualified long-term care contract. Swapping an annuity for life insurance is not allowed and is fully taxable, as confirmed by Revenue Ruling 2003-76 and the PPA guidance. A common misconception is that “insurance is insurance,” but the direction rule is strict. Verify the product type on the application before funds move.

How Your Cost Basis Carries Over (w/Example)

In a 1035 exchange your cost basis — the after-tax money you originally paid in — carries over to the new annuity unchanged. Under Section 1031(d), which Section 1035 borrows for basis rules, the new contract takes the same adjusted basis as the old one. This matters because basis is the part you get back tax-free when you eventually withdraw.

Here is a fully worked, non-qualified example you can copy:

Margaret, age 61, owns a non-qualified deferred annuity. She paid in $100,000 of after-tax money, and it has grown to $160,000. She wants out because the contract charges 2.4% a year in fees.

Current account value: $160,000
Original cost basis (after-tax premiums): $100,000
Embedded gain (untaxed): $160,000 − $100,000 = $60,000

If Margaret surrendered the annuity for cash, she would owe ordinary income tax on the full $60,000 gain. At a 24% bracket for 2025, that is $14,400 in federal tax, plus a possible state hit.

If Margaret instead does a 1035 exchange into a low-fee annuity:

Tax owed today: $0
New contract value: $160,000
New contract basis: $100,000 (carried over)
Gain still deferred: $60,000

She keeps all $160,000 working and pays nothing now. The $60,000 gain stays deferred until she withdraws it later, ideally in a lower-income retirement year.

The 10% Penalty and Age 59½ Trap

A 1035 exchange itself never triggers the 10% early-withdrawal penalty, because no money is distributed to you. But the penalty waits in the wings. If you are under age 59½ and you withdraw from the new contract after the swap, you can owe a 10% federal penalty on the taxable portion on top of ordinary income tax.

The consequence is a layered tax: ordinary income tax plus 10%. For a $60,000 gain pulled out at 56, that penalty alone is $6,000 on top of the regular tax. The fix is to treat the exchange as a continuation of your existing investment timeline — move the contract, but leave the gains untouched until 59½ or later.

Surrender Charges Do Not Disappear

A common and expensive misunderstanding is that a 1035 exchange wipes out surrender charges. It does not. A 1035 exchange protects you from income tax, not from your insurer’s contractual surrender penalty. If your old annuity is still inside its surrender period, the carrier can deduct a surrender charge before sending the money — and that charge reduces the value that lands in your new contract, as explained by Accounting Insights.

For example, a 6% surrender charge on a $160,000 annuity costs $9,600 of real money. The consequence is a permanently smaller balance, with no tax deduction for the loss. What to do: ask your carrier for the exact surrender charge in writing, and consider waiting until the surrender period ends or until the next “free withdrawal” window before exchanging.

Partial 1035 Exchanges and the 180-Day Rule

You do not have to move the entire annuity. A partial 1035 exchange lets you transfer only part of one annuity’s value into a new annuity, tax-free. In Revenue Ruling 2003-76, the IRS approved moving 60% of an annuity’s cash value to a new carrier, and ruled that 60% of the basis follows the money while 40% stays behind.

The danger is the 180-day rule from Notice 2011-68 and the related guidance. If you take a non-annuity withdrawal from either contract within 180 days of a partial exchange, the IRS can retroactively recharacterize the move and tax the gain. The consequence is that a clean partial exchange becomes a taxable distribution after the fact.

Worked partial example: David owns an annuity worth $200,000 with a $120,000 basis. He moves 25% ($50,000) to a new annuity. His basis splits proportionally — $30,000 (25%) goes to the new contract and $90,000 stays in the old one. If David leaves both contracts alone for 180 days, the move stays tax-free. If he pulls cash out on day 90, he risks taxation on the gain. What to do: calendar the 180-day mark and avoid withdrawals until it passes.

Which Situation Applies to You?

The right path depends on what kind of annuity you hold and why you want to move.

You own a non-qualified annuity (bought with after-tax money) and want a better contract: A standard 1035 exchange is your tool — read the basis and rules sections above.
You own a qualified annuity inside an IRA or 401(k): This is not a 1035 exchange. Use a trustee-to-trustee transfer or rollover instead — see the next section.
You want to keep part of your old annuity: Use a partial 1035 exchange and mind the 180-day rule.
You need long-term care coverage: You can do a 1035 exchange from an annuity into a qualified long-term care contract.
You are still inside the surrender period: Run the surrender-charge math first; waiting may save thousands.

Qualified vs. Non-Qualified: A Critical Difference

Section 1035 applies only to non-qualified annuities — those bought with after-tax dollars outside a retirement plan. If your annuity sits inside an IRA, 401(k), or 403(b), it is qualified, and you do not use a 1035 exchange at all. You use a tax-free rollover or trustee-to-trustee transfer under the retirement-account rules.

Mixing these up is one of the costliest errors in this area. Forcing a “1035” label on an IRA annuity, or taking a check from an IRA annuity and missing the 60-day rollover window, can trigger full taxation plus a 10% penalty if you are under 59½.

Feature	Non-Qualified Annuity (1035)	Qualified Annuity (IRA/401k)
Funded with	After-tax dollars	Pre-tax dollars (usually)
Tax-free move method	1035 exchange	Rollover or trustee transfer
What carries over	Cost basis	Full pre-tax balance
Taxable part later	Only the gain	Generally the whole withdrawal
Wrong-move risk	Gain taxed if check is taken	Full balance taxed if 60-day rule missed

Old Rule vs. New Rule: What Changed

Annuity exchange treatment has expanded over time, and knowing the timeline keeps you from relying on outdated advice.

Era	What Was Allowed
Before 2010	Annuity-to-annuity tax-free; no annuity-to-LTC option
After Dec. 31, 2009 (PPA)	Annuity can be exchanged tax-free into a qualified long-term care contract
2003 ruling forward	Partial annuity exchanges allowed (Rev. Rul. 2003-76)
2011 guidance	180-day window set for partial exchanges via Notice 2011-68

The practical takeaway is that annuity-to-LTC exchanges and partial exchanges are both firmly allowed today, but each carries its own conditions. Confirm the current carrier paperwork supports the specific move you want.

Three Named Scenarios

Below are three common situations, each shown as what you do versus what it costs you.

Scenario 1 — Escaping high fees (Margaret).

Margaret’s Move	The Result
1035 exchange from a 2.4%-fee variable annuity into a 0.6%-fee annuity	$0 tax today; $60,000 gain stays deferred; she saves roughly $2,880 a year in fees
Surrender for cash instead	$14,400 federal tax now plus lost deferral

Scenario 2 — Locking in a better income rider (Robert).

Robert’s Move	The Result
1035 exchange into an annuity with a stronger guaranteed lifetime withdrawal benefit	Tax-free transfer; higher guaranteed income base; basis carries over
Cancels old contract and rebuys	Triggers tax on the gain and resets the surrender clock anyway

Scenario 3 — Consolidating two annuities (Linda).

Linda’s Move	The Result
1035 exchange of an older annuity into her existing newer one (assignment into a preexisting contract, allowed under Rev. Rul. 2002-75)	One contract, simpler management, tax-free
Withdraws from the old one to fund the new	Full gain taxed as ordinary income

The Form and Process Step by Step

There is no separate IRS form you file for a 1035 exchange. The paperwork is the new insurer’s 1035 exchange/absolute assignment form, and the tax reporting happens automatically through Form 1099-R, which the old carrier issues with distribution code 6 to flag a tax-free 1035 exchange.

Apply for the new annuity and tell the agent it will be funded by a 1035 exchange.
Complete the carrier’s 1035 transfer form, naming the old contract and authorizing a direct transfer.
The new insurer requests the funds directly from the old insurer — you never receive a check.
The old carrier deducts any surrender charge and wires the balance.
You receive a 1099-R with code 6 the following January; report it, but the exchange itself is not taxable.

The whole process usually takes two to six weeks. The cost is generally $0 in fees from the new carrier, but watch for surrender charges and a fresh surrender period on the new contract. If your situation involves a large gain, a partial exchange, or an IRA annuity, that is the point to call a CPA or tax attorney; expect roughly $200 to $500 for a focused consultation.

Mistakes to Avoid

Taking a check yourself. This triggers full taxation under Rev. Rul. 2007-24 — all gain becomes income now.
Changing the owner during the swap. Different owners void the tax-free treatment and may create a taxable gift.
Trying to exchange an annuity into life insurance. The direction is banned and the move is fully taxable.
Withdrawing within 180 days of a partial exchange. This can retroactively tax the gain under Notice 2011-68.
Ignoring surrender charges. A 1035 exchange shields you from tax, not from a 6%–8% carrier penalty.
Confusing an IRA annuity with a 1035. Qualified annuities use a rollover; the wrong route can tax the whole balance.
Exchanging a contract with a loss without checking the rules. Section 1035 generally bars recognizing a loss, so you may forfeit a deductible loss by exchanging instead of surrendering.

Do’s and Don’ts

Do:

Do confirm both contracts are annuities (or a qualified LTC contract) — the direction rule controls whether it stays tax-free.
Do keep the owner and annuitant identical, because the regulation requires the same obligee.
Do use a direct insurer-to-insurer transfer, since touching the money makes it taxable.
Do get the surrender charge in writing first, because it shrinks your new balance permanently.
Do compare the new contract’s fees, riders, and surrender period, since a “tax-free” swap can still be a bad deal.

Don’t:

Don’t accept a check, because endorsing it to the new carrier is treated as a taxable distribution.
Don’t withdraw within 180 days of a partial exchange, or you risk losing the tax-free status.
Don’t assume new equals better, since a fresh surrender period locks your money up again.
Don’t exchange an IRA annuity as a 1035, because that label does not apply to qualified money.
Don’t surrender a losing annuity without checking whether a separate surrender lets you claim the loss.

Pros and Cons

Pros:

Tax deferral preserved — you avoid tax on the gain today, keeping more money compounding.
Lower fees possible — moving from a 2%+ contract to a low-cost one can save thousands a year.
Better features — newer contracts may offer stronger income riders or death benefits.
Basis carries over — your after-tax contributions stay tax-free when withdrawn later.
Partial moves allowed — you can split a contract and keep part of the old one.

Cons:

Surrender charges still apply — the old carrier’s penalty is not waived by tax law.
New surrender period — your money gets locked up again, often 5–10 years.
No loss deduction — Section 1035 generally blocks recognizing a loss on the old contract.
Complexity and timing traps — the 180-day rule and direct-transfer rule are easy to break.
Possible lost benefits — leaving an old contract can forfeit a valuable legacy rider or rate.

What to Do Next

Gather your old contract details: account value, cost basis, surrender charge, and rider benefits.
Decide full vs. partial based on whether you want to keep any of the old annuity.
Confirm the new contract is an annuity or qualified LTC and that fees and surrender terms are better.
Sign the new carrier’s 1035 transfer form and let the insurers move the money directly — never take a check.
Mark 180 days on your calendar if it is a partial exchange, and avoid withdrawals until then.
Watch for the code-6 Form 1099-R next January and keep it with your tax records.
Call a CPA or tax attorney if your gain is large, the annuity is inside an IRA, or you are under 59½.

This article is educational and is not a substitute for personalized advice from a licensed tax professional, CPA, or financial advisor for your specific situation. A state’s income tax may or may not follow federal 1035 treatment; most states with an income tax conform, but confirm with your state’s department of revenue before you act.

FAQs

Can you 1035 exchange one annuity for another?

Yes. Under Section 1035, you can swap a non-qualified annuity for another annuity tax-free for 2025, as long as the owner stays the same and the insurer transfers the money directly.

Does a 1035 exchange avoid surrender charges?

No. A 1035 exchange avoids income tax, not your insurer’s surrender penalty. If the old annuity is still in its surrender period, the carrier can deduct a charge before transferring the money.

Can I exchange an annuity for life insurance?

No. The law lets you go from life insurance to an annuity, but never the reverse. An annuity-to-life-insurance swap is fully taxable on the gain.

Is a 1035 exchange reported to the IRS?

Yes. The old carrier issues a Form 1099-R with distribution code 6, which flags a tax-free 1035 exchange. You report the form, but no tax is due on the exchange itself.

What happens to my cost basis in a 1035 exchange?

It carries over. Under Section 1031(d), the new annuity keeps the same after-tax basis as the old one, so your tax-free return of premium stays intact.

Can I do a partial 1035 exchange?

Yes. Rev. Rul. 2003-76 allows moving part of an annuity’s value, with basis splitting proportionally. Avoid withdrawals for 180 days afterward to keep it tax-free.

Does a 1035 exchange trigger the 10% early-withdrawal penalty?

No. The exchange itself distributes nothing to you, so no penalty applies. The 10% penalty can apply only if you later withdraw gains from the new contract before age 59½.

Can I 1035 exchange an IRA annuity?

No. Section 1035 is only for non-qualified annuities. An annuity inside an IRA uses a trustee-to-trustee transfer or rollover instead.

How long does a 1035 exchange take?

Two to six weeks in most cases. The new insurer requests funds from the old carrier, which processes the transfer directly after deducting any surrender charge.

Can I exchange an annuity for long-term care insurance?

Yes. Since exchanges after 2009, the Pension Protection Act lets you do a tax-free 1035 exchange from an annuity into a qualified long-term care insurance contract.

Can I claim a loss in a 1035 exchange?

No. Section 1035 is a nonrecognition rule, so it generally blocks a deductible loss. If your annuity has a loss, surrendering it (not exchanging) may be the only way to claim it.

Does my state tax a 1035 exchange?

Usually no. Most states that levy an income tax conform to federal 1035 treatment, so the exchange is also tax-free at the state level. Confirm with your state’s department of revenue, since conformity is not guaranteed.

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