Can You 1035 Into a Hybrid Long-Term Care Annuity? (w/Examples) + FAQs

This article reflects federal rules and general state-conformity rules as of June 2026 and covers tax year 2025 (with 2026 figures noted where they apply). Tax law changes — confirm current figures before you act. This guide is educational and is not a substitute for advice from a licensed CPA, tax attorney, or insurance professional for your specific situation.

Quick Answer

Yes. A Section 1035 exchange lets you move a non-qualified annuity or cash-value life insurance into a hybrid long-term care (LTC) annuity tax-free, and qualified care withdrawals come out income-tax-free too. The Pension Protection Act of 2006 made this possible starting January 1, 2010.

Many people are sitting on an old deferred annuity they no longer need for income — often one carrying a built-in gain they do not want to pay tax on. Cashing it out triggers ordinary income tax on every dollar of gain, but a properly structured 1035 exchange into a hybrid LTC annuity moves that money without a tax bill and turns the gain into a pool of tax-free long-term care dollars.

The stakes are real and the timing matters. The U.S. Department of Health and Human Services estimates that about 70% of people turning 65 will need some form of long-term care in their lifetime, yet most have no dedicated funding for it. Here is what you will learn:

✅ The exact rule that makes annuity-to-LTC exchanges tax-free — and the one type of money it does not cover.
💰 A fully worked example showing a $100,000 annuity with a $40,000 gain repositioned into 2–3x in tax-free care benefits.
⚠️ Seven costly mistakes that can blow up the tax-free treatment and trigger a surprise 1099-R.
🧭 A decision aid to tell whether an annuity hybrid, a life-insurance hybrid, or standalone LTC fits you.
📋 The forms, codes, and deadlines — including what Box 7 Code 6 and Code W mean on your tax statements.

What a “Hybrid Long-Term Care Annuity” Actually Is

A hybrid long-term care annuity — also called an asset-based or linked-benefit LTC annuity — is a single contract that does two jobs. It works like a deferred annuity that holds and grows your money, and it adds a long-term care benefit that pays a multiple of your contract value if you need qualified care. Carriers like OneAmerica’s State Life Annuity Care and the Nationwide CareMatters Annuity are common examples of this design.

The “hybrid” part is the leverage. You put in a lump sum, and the contract creates an LTC benefit pool worth two or three times (sometimes more) that amount. If you never need care, the annuity value still belongs to you or your heirs. If you do need care, the contract first spends your own money, then taps the larger insured pool — and qualified withdrawals come out income-tax-free under Section 7702B.

This is different from a life insurance hybrid, which is built to deliver a death benefit first and accelerates it for care second. The annuity hybrid is built to solve for care first and preserves whatever is left as a value to you or your beneficiaries. Knowing which job you want done is the single most important decision before you exchange anything.

The three eligible products you can land in

Under the rules, a 1035 exchange must move into a “like-kind” contract, and the Pension Protection Act expanded that list. From a non-qualified annuity, you can exchange into another annuity, into a qualified LTC contract, or into a hybrid annuity that includes a qualified LTC rider. You cannot exchange an annuity into a stand-alone life insurance policy — that direction is not allowed.

The practical landing spots are a hybrid LTC annuity (annuity chassis), a hybrid LTC life insurance policy (life chassis, only reachable from a life policy or, in limited designs, from an annuity through the carrier’s structure), or a stand-alone tax-qualified LTC policy. Each carries different tax mechanics, which is why the source contract you start with controls where you are allowed to go.

The One Rule That Controls Everything: Section 1035 + the Pension Protection Act

IRC Section 1035 lets you swap one insurance or annuity contract for another like-kind contract without recognizing gain at the time of the exchange. Before 2010, you could not use it to fund long-term care. The Pension Protection Act changed that by adding qualified LTC contracts to the list of permitted 1035 targets, effective January 1, 2010.

The consequence of getting this wrong is expensive. If you surrender the old annuity and take the cash instead of doing a direct carrier-to-carrier exchange, the gain becomes ordinary income that year — and if you are under 59½, a 10% early-distribution penalty can stack on top. A real exchange avoids all of that because the money never touches your hands.

Here is the rule in action. Maria, age 64, owns a non-qualified deferred annuity worth $100,000 that she bought with $60,000, leaving a $40,000 gain. If she cashes it out, that $40,000 is taxed as ordinary income. If she instead does a 1035 exchange into a hybrid LTC annuity, no tax is due now, and the gain inside the contract can later pay for care tax-free.

A common misconception is that “tax-free” means “no taxes ever.” It does not. The exchange defers tax, and the LTC benefit makes qualified care withdrawals tax-free — but a non-care surrender down the road can still pull the original gain out as taxable income.

What to do about it: insist on a direct (trustee-to-trustee style) 1035 exchange in writing, never a “cash now, buy later” plan, and confirm the new contract is a tax-qualified Section 7702B LTC contract before you sign.

Qualified money does NOT qualify — the trap that catches everyone

This is the mistake that ruins more plans than any other. Section 1035 and the Pension Protection Act LTC exchange apply only to non-qualified money — annuities and life policies you bought with after-tax dollars. IRAs, 401(k)s, 403(b)s, and other pre-tax retirement accounts cannot use a 1035 exchange into an LTC annuity.

If you try to move IRA money this way, you do not get a tax-free exchange — you get a taxable distribution of the entire amount, plus a possible 10% penalty if you are under 59½. The consequence can be tens of thousands in unexpected tax on a single transaction.

What to do about it: if your money is in an IRA or 401(k), talk to a planner about a separate strategy (some carriers offer qualified-money LTC funding over a period of years), and never assume the 1035 rules apply to retirement accounts. When in doubt, the dividing line is simple: did you already pay tax on this money? If no, it is not 1035-eligible.

Which Situation Applies to You?

The right move depends on what money you have and what you want it to do. Use the branches below to find the part of this guide that fits you, because one size genuinely does not fit all here.

You own an old non-qualified annuity you do not need for income → the annuity-to-LTC-annuity 1035 exchange in this guide is built for you.
You own cash-value life insurance you no longer need → you can 1035 into a hybrid life/LTC policy or an LTC annuity; the life-to-life route also preserves a death benefit.
Your money is in an IRA or 401(k) → stop; 1035 does not apply, and you need a different (often multi-year) funding strategy.
You want care coverage first and value preservation second → the annuity hybrid usually fits best.
You want a death benefit first with care as a backup → a life-insurance hybrid with an LTC rider usually fits better.

How Hybrid LTC Annuities Are Taxed (Federal)

The tax story has three stages, and each matters. First, the 1035 exchange itself is tax-free under Section 1035, so moving the old contract triggers no current income. Second, the contract grows tax-deferred like any annuity. Third — and this is the Pension Protection Act benefit — withdrawals used for qualified long-term care come out income-tax-free.

There is a subtle but important wrinkle on the cost basis. Internal charges the contract deducts to pay for the LTC coverage reduce your annuity’s cost basis but are not taxable to you, thanks to Section 72(e)(11). That means your basis shrinks over time even though you never receive or owe tax on those charges — a detail that surprises owners who later surrender for cash.

Qualified LTC benefits are tax-free, but only up to limits if the contract pays on an indemnity (per-diem) basis. For tax year 2025, per-diem benefits are excluded from income up to the greater of actual qualified care costs or $420 per day, per IRS Revenue Procedure 2024-40. For 2026 that per-diem limit rises to $430 per day under Rev. Proc. 2025-32. Reimbursement-based contracts that pay actual costs are not capped by the per-diem figure.

The forms and codes you will see

A 1035 exchange is non-taxable but reportable, so the surrendering carrier issues a Form 1099-R. The exchange shows Box 7 Code 6, which signals a tax-free Section 1035 exchange of a life, annuity, LTC, or endowment contract. Seeing a 1099-R does not mean you owe tax — it documents the move.

Separately, once the hybrid contract is paying internal LTC charges against the annuity value, you may receive a 1099-R with Box 7 Code W. Code W reports charges for qualified LTC coverage under a combined arrangement that are excludable under Section 72(e)(11). These amounts are not taxable income; they simply reduce your basis. When you actually receive LTC benefits, the carrier reports them on Form 1099-LTC, which the AALTCI explains in plain terms.

A Fully Worked Example (Copy the Math)

Let us run Maria’s numbers in full so you can follow every step. Maria, age 64, owns a non-qualified deferred annuity. She paid $60,000 (her basis), it has grown to $100,000, so she has a $40,000 gain sitting inside it.

Option 1 — She surrenders for cash. The entire $40,000 gain is ordinary income in 2025. At a 24% federal bracket, that is $9,600 in federal tax, leaving her about $90,400. Because she is over 59½, there is no 10% penalty — but if she were 58, the penalty would add another $4,000.

Option 2 — She does a 1035 exchange into a hybrid LTC annuity. No tax is due now on the $40,000 gain. The full $100,000 moves into the contract, and the hybrid’s leverage (say a 2.5x benefit multiple) creates an LTC pool of about $250,000. If Maria later needs care, those benefits pay out income-tax-free under the Pension Protection Act.

The contrast is stark. Surrendering hands the IRS $9,600 today and gives her $90,400 of taxable-when-spent money. The 1035 exchange keeps the full $100,000 working, defers the $40,000 gain, and converts it into roughly $250,000 of tax-free care coverage — leverage and tax savings she cannot get any other way.

Maria’s choice (age 64, $100k value, $40k gain)	Tax and care result
Surrender annuity for cash	$40,000 taxed as income; about $9,600 federal tax; no care benefit
1035 exchange into hybrid LTC annuity	$0 tax now; ~$250,000 tax-free LTC pool; gain deferred

Three Common Scenarios

Most readers fall into one of three buckets. Each shows how the rule plays out and what the tax result is.

Your starting contract and goal	What happens on a 1035 exchange
Non-qualified annuity with a gain, no longer needed for income	Tax-free move into a hybrid LTC annuity; gain deferred; care withdrawals tax-free
Old cash-value life insurance you no longer need	Can 1035 into a hybrid life/LTC policy or an LTC annuity; life route keeps a death benefit
Annuity bought at a loss (value below basis)	Exchange still works, but consider whether a deductible loss strategy fits better first

Funding source you want to use	Whether a 1035 LTC exchange is allowed
Non-qualified (after-tax) annuity or life policy	Allowed and tax-free under Section 1035 and the Pension Protection Act
IRA, 401(k), 403(b), or other pre-tax account	Not allowed; a 1035 attempt becomes a taxable distribution

Care-funding priority	Best-fit product
Protect assets and pay for care first	Hybrid LTC annuity (annuity chassis)
Leave a death benefit, with care as a backup	Hybrid life policy with LTC rider

Three Named Examples

Robert, age 67 (Florida). Robert holds a $150,000 non-qualified annuity with a $50,000 gain he will never use for income. He does a direct 1035 exchange into a hybrid LTC annuity with a 3x benefit, creating roughly a $450,000 tax-free care pool, and defers the $50,000 gain entirely. Florida has no state income tax, so his only tax concern is federal — and that is deferred.

Susan, age 58 (California). Susan wants to reposition a $90,000 annuity with a $30,000 gain. Because she is under 59½, surrendering would cost her income tax plus a 10% penalty on the gain — about $3,000 in penalty alone. A 1035 exchange avoids both, and California, which does not always follow every federal insurance preference, still respects the federal 1035 deferral on the exchange itself.

James, age 71 (Texas). James owns a paid-up cash-value life policy he no longer needs. He 1035-exchanges it into a hybrid life/LTC policy, keeping a death benefit for his kids while adding tax-free care coverage. His age means his standalone LTC premium deduction cap would be $6,020 for 2025, but inside the hybrid the internal charges are simply non-taxable basis reductions instead.

Federal vs. State: Does Your State Follow This?

Start with the federal rule, because it is the anchor: the 1035 exchange and the tax-free LTC benefit are federal provisions, and they apply nationwide. The exchange is not a taxable event federally, and qualified care benefits are federally income-tax-free.

States are where it gets uneven, and you cannot assume conformity. Most states follow the federal treatment of a 1035 exchange because they start from federal adjusted gross income, so the exchange is usually state-tax-free as well. But states differ sharply on whether they offer an LTC premium deduction or credit, and a handful do not conform to every federal insurance provision.

The good news for many readers is geography. No-income-tax states such as Florida, Texas, Nevada, Washington, and Wyoming do not tax the gain at all, so the federal answer is the whole answer. In income-tax states, confirm with your state department of revenue whether an LTC credit or deduction applies — for example, several states offer their own LTC insurance credits that a hybrid contract may or may not qualify for.

Deadlines, Costs, and Timing

There is no IRS filing deadline to start a 1035 exchange — you can do it any time — but timing still matters. Once you begin, the surrendering carrier sends funds directly to the new carrier, and the process typically takes two to six weeks depending on the companies involved. Surrender charges on the old contract can apply, so check whether your old annuity is still inside its surrender period.

Cost-wise, the exchange itself usually carries no fee from the receiving carrier, but the old contract may impose a surrender charge if you are early. Doing it yourself through an agent is generally free of advisory fees; a fee-only planner’s review might run $200 to $500 an hour or a flat project fee. The reporting deadline is automatic — your 1099-R arrives by January 31 of the following year.

Mistakes to Avoid

Taking the cash first, then buying. This breaks the exchange and makes the entire gain taxable that year.
Using IRA or 401(k) money. Pre-tax accounts are not 1035-eligible; the attempt becomes a fully taxable distribution.
Assuming “tax-free” covers non-care withdrawals. Surrendering for cash later still pulls the gain out as ordinary income.
Ignoring surrender charges on the old contract. Exchanging during the surrender period can cost a percentage of value you never recover.
Exchanging an annuity into life insurance. That direction is not permitted under Section 1035 and voids the tax-free treatment.
Panicking over a Code 6 or Code W 1099-R. Treating a reportable-but-nontaxable form as taxable can cause you to overpay.
Skipping the suitability and health review. Hybrid LTC contracts require underwriting; assuming approval before applying can leave you with funds in limbo.

Do’s and Don’ts

Do’s

Do insist on a direct carrier-to-carrier exchange — it is the only way to keep the gain untaxed.
Do confirm the new contract is a Section 7702B qualified LTC contract — only qualified contracts get tax-free care benefits.
Do match the chassis to your goal — annuity-first for care, life-first for a death benefit.
Do check your old contract’s surrender period — exiting early can cost real money.
Do keep your basis records — internal LTC charges shrink basis and affect a future surrender.

Don’ts

Don’t move qualified retirement money — it is not 1035-eligible and triggers tax.
Don’t assume your state grants an LTC credit — conformity varies, so verify it.
Don’t surrender for cash to “simplify” — you lose the entire tax deferral.
Don’t overlook underwriting — hybrid annuities still require health questions.
Don’t sign without comparing benefit multiples — leverage differs widely between carriers.

Pros and Cons

Pros

Tax-free repositioning of a gain-heavy annuity you no longer need.
Leverage that turns one dollar into two or three dollars of care coverage.
Tax-free qualified care benefits under the Pension Protection Act.
Value preservation — unused funds stay with you or your heirs.
No “use it or lose it” problem that plagues traditional LTC premiums.

Cons

Money is committed — large surrenders for non-care needs can be taxable.
Underwriting required — poor health can mean denial.
Lower liquidity during the surrender period of the new contract.
Complexity — the tax forms and basis tracking confuse many owners.
Opportunity cost — funds locked in a hybrid may earn less than other investments.

What to Do Next

Confirm your money is non-qualified (after-tax) — if it is in an IRA or 401(k), stop and seek a separate strategy.
Pull your old contract’s current value, cost basis, and surrender-charge schedule from the issuing carrier.
Decide your priority — care first (annuity hybrid) or death benefit first (life hybrid).
Request a direct 1035 exchange in writing; never take a check yourself.
Compare benefit multiples and underwriting across at least two carriers such as OneAmerica and Nationwide.
If the gain is large, your money is partly qualified, or an estate is involved, call a CPA or fee-only planner before signing.

FAQs

Can you 1035 an annuity into a long-term care annuity?

Yes. Since the Pension Protection Act took effect January 1, 2010, a non-qualified annuity can be exchanged tax-free into a qualified hybrid LTC annuity under Section 1035, with no current tax on the gain.

Is a 1035 exchange taxable?

No. The exchange itself is tax-free, though it is reportable. The surrendering carrier issues a Form 1099-R with Box 7 Code 6 to document the tax-free Section 1035 exchange.

Can I 1035 my IRA into a long-term care annuity?

No. IRAs and other pre-tax retirement accounts are not eligible for a 1035 LTC exchange. Attempting it creates a fully taxable distribution, plus a possible 10% penalty if you are under 59½.

Can I exchange life insurance into a long-term care annuity?

Yes. Cash-value life insurance can be 1035-exchanged into an LTC annuity or a hybrid life/LTC policy. You cannot, however, exchange an annuity into a life insurance policy.

What is the per-diem LTC benefit limit?

$420 per day for tax year 2025, rising to $430 per day for 2026 under Rev. Proc. 2025-32. Indemnity benefits above this (or above actual care costs) can become taxable.

What does Code W on a 1099-R mean?

Code W reports charges deducted from your contract to pay for qualified LTC coverage under a combined arrangement. These amounts are not taxable income; they reduce your cost basis under Section 72(e)(11).

Are hybrid LTC annuity care benefits really tax-free?

Yes. Qualified long-term care benefits from a tax-qualified Section 7702B contract are income-tax-free, subject to the per-diem limit only if the contract pays on an indemnity basis.

Will my state tax the exchange?

Usually not. Most states begin from federal income and follow the federal 1035 deferral, and no-income-tax states like Florida and Texas do not tax it at all. Confirm any LTC credit with your state.

Do I need to be in good health to qualify?

Yes. Hybrid LTC annuities require underwriting, usually health questions and sometimes a phone interview. Poor health can reduce the benefit multiple or lead to a denial.

How long does a 1035 exchange take?

About two to six weeks, depending on the carriers. Funds move directly between companies, and you receive a Form 1099-R by January 31 of the following year documenting the tax-free exchange.

What happens if I surrender the hybrid later for cash?

The original gain becomes taxable. A non-care surrender pulls out the deferred gain as ordinary income, and internal LTC charges that lowered your basis can make the taxable amount larger than expected.

Can a married couple share one hybrid LTC annuity?

Yes, with some carriers. Joint or shared-benefit designs from issuers like OneAmerica let a couple pool coverage, though terms, benefit multiples, and underwriting vary by company and state.

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