Does a 1035 Exchange Avoid the 3.8% NIIT on Annuity Gains? (w/Examples) + FAQs

This article reflects federal rules as of June 2026 and covers tax year 2025 (returns filed in 2026). The 3.8% Net Investment Income Tax is a federal-only tax — no state imposes its own version. Tax law changes, so confirm current figures with the IRS Net Investment Income Tax page before you file.

Quick Answer

No — a 1035 exchange does not avoid the 3.8% Net Investment Income Tax (NIIT) on nonqualified annuity gains. It defers it. Done correctly under IRC Section 1035, the swap triggers no taxable income, so no NIIT applies in the exchange year. The gain — and the NIIT — wait until you withdraw.

There is a real difference between “avoid” and “defer,” and confusing the two can cost you real money. A 1035 exchange lets you move from one annuity to a better one without reporting the built-in gain today, which means the 3.8% surtax does not apply in the year you exchange. But your old, low cost basis carries over to the new contract, so every dollar of deferred gain is still there — and the day you take a taxable distribution, that gain can land in your Net Investment Income and get hit with the 3.8% tax if your income is high enough.

This matters because the NIIT thresholds have never been adjusted for inflation since the tax began on January 1, 2013, so more retirees cross the line every year (see the IRS NIIT overview). Whether you are switching to a lower-fee annuity, escaping a poor insurer, or consolidating contracts, the timing of your gain — and your modified adjusted gross income in the year you finally withdraw — decides whether the 3.8% tax bites.

Here is what you will learn:

🔄 How a 1035 exchange defers (not erases) the gain on a nonqualified annuity, and why the carryover basis is the key.
🧮 A step-by-step worked example showing the exact 3.8% tax saved this year and owed later.
⚠️ The “boot,” partial-exchange, and direct-receipt traps that turn a tax-free swap into a taxable event plus NIIT.
🏦 Why qualified (IRA/401(k)) annuities almost never face the NIIT, while nonqualified annuities do.
📋 Exactly which forms to watch — Form 1099-R code “D” and Form 8960 — and what to do next.

What a 1035 Exchange Actually Does

A 1035 exchange is a tax-free swap of one insurance or annuity contract for another, named after Section 1035 of the tax code. Congress wrote it so that people who want to upgrade an old policy — for lower fees, better features, or a stronger insurer — are not punished with a tax bill just for switching. The Investor.gov definition of Section 1035 explains that you can exchange an existing annuity for a new annuity “without paying tax on the income and investment gains in your current account.”

The word that matters is defer, not avoid. A 1035 exchange postpones the gain by carrying your old cost basis into the new contract. So if you put $100,000 into an annuity that grew to $160,000, your $60,000 of gain does not vanish in the exchange — it rides along, and your basis in the new contract stays $100,000.

The consequence of getting this wrong is steep. If you instead surrender the old annuity, take the cash, and buy a new one yourself, that is not a 1035 exchange — it is a taxable surrender, and the full $60,000 gain becomes ordinary income that year, potentially plus the 3.8% NIIT. The fix is simple but strict: the money must move insurer to insurer, never through your hands.

Which transfers qualify under Section 1035

The tax code allows only certain “like-to-like” swaps. Per IRS Revenue Ruling 2007-24 and the statute, you can exchange an annuity for another annuity, a life policy for an annuity, or (since the Pension Protection Act of 2006) a life or annuity contract for qualified long-term care insurance, as the American Association for Long-Term Care Insurance explains.

You cannot go the other direction — an annuity cannot be exchanged tax-free into a life insurance policy, because that would convert taxable annuity gain into a tax-free death benefit. The consequence of attempting it is a fully taxable surrender. A common misconception is that “any insurance product swaps for any other”; in reality the allowed directions are one-way for life and LTC contracts. Before you sign, confirm with your new insurer in writing that the transfer is being processed as a 1035 exchange.

Carryover basis — the detail that controls your future NIIT

In a 1035 exchange, your cost basis (the after-tax money you put in) carries over to the new contract, and so does your deferred gain. This single rule is why the NIIT is deferred, not avoided.

Say your basis is $100,000 and the contract is worth $160,000. After the exchange, the new annuity still has a $100,000 basis and a $60,000 embedded gain. When you eventually withdraw, the earnings come out first under the “last-in, first-out” rule of IRC Section 72, so the taxable gain — and any NIIT exposure — surfaces then. The reader’s action item: keep every basis record from the old contract, because the new insurer may not have it, and you will need it to prove how much of a future withdrawal is tax-free return of principal.

Why Annuity Gains Can Trigger the 3.8% NIIT

The Net Investment Income Tax is a 3.8% federal surtax on investment income for higher earners, created by the Affordable Care Act and effective January 1, 2013. The IRS explains that it applies to the lesser of your net investment income or the amount your modified adjusted gross income (MAGI) exceeds a fixed threshold.

Distributions of earnings from nonqualified annuities are explicitly listed as net investment income, as the Ameriprise NIIT guide confirms. So the taxable gain you pull out of a nonqualified annuity is exactly the kind of income the 3.8% tax targets. The consequence: a retiree who takes a large annuity withdrawal in a high-income year can owe the 3.8% tax on top of ordinary income tax.

The misconception here is that “the NIIT is a tax on the exchange.” It is not. The exchange itself produces no income, so there is nothing for the NIIT to grab. The tax only appears when you take a taxable distribution. What to do: model your MAGI in any year you plan a withdrawal, because the surtax depends on income that year — not on what you did during the exchange.

The NIIT thresholds for tax year 2025

For tax year 2025, the MAGI thresholds — straight from the IRS NIIT page — are $200,000 for single or head of household, $250,000 for married filing jointly, $125,000 for married filing separately, and $250,000 for a qualifying surviving spouse.

These numbers are not indexed for inflation and have not changed since 2013. The consequence is “threshold creep”: as incomes and account values rise, more middle-class retirees get pulled in each year. A frequent misconception is that the tax applies to your whole investment income once you cross the line; in fact it applies only to the lesser of your excess MAGI or your net investment income. Action: if you are near a threshold, spreading a withdrawal across two tax years can keep you under it.

How the NIIT math works

You owe 3.8% on the lesser of two amounts: your total net investment income, or the dollars by which your MAGI exceeds your threshold. This “lesser of” design is the taxpayer’s friend, because it caps the base.

Consider a married couple with $230,000 MAGI, of which $30,000 is annuity earnings. Their MAGI is under the $250,000 joint threshold, so their NIIT is $0 — even though they have investment income. Now raise their MAGI to $300,000 with the same $30,000 of annuity earnings: the excess over the threshold is $50,000, but net investment income is only $30,000, so the tax is 3.8% of the lesser figure, $30,000 — about $1,140. The action step: always run both numbers, because the smaller one wins.

Worked Example: The 3.8% Saved Now vs. Owed Later

Money examples make this concrete. Here is the full math, the kind IRS.gov will not hand you.

Assume Margaret, a single filer, owns a nonqualified annuity. She paid $100,000 (her basis) and it is now worth $160,000, so she has $60,000 of embedded gain. Her MAGI without any annuity income is $190,000 for tax year 2025.

Scenario A — She does a proper 1035 exchange. The contract moves insurer-to-insurer into a lower-fee annuity. No gain is reported. Her taxable income does not change, her MAGI stays $190,000 (below the $200,000 single threshold), and her NIIT for the year is $0. The $60,000 gain and her $100,000 basis carry to the new contract.

Scenario B — She surrenders instead and takes the cash. The $60,000 gain becomes ordinary income now. Her MAGI jumps to $250,000. Her excess over the $200,000 threshold is $50,000; her net investment income is $60,000; the NIIT applies to the lesser, $50,000, so she owes 3.8% × $50,000 = $1,900 in NIIT — plus ordinary income tax on the full $60,000. The 1035 exchange in Scenario A saved her that $1,900 surtax this year.

Scenario C — Five years later she withdraws the gain. Under the LIFO rule of Section 72, earnings come out first. If she pulls the $60,000 of gain in a year her MAGI lands at $230,000, her excess over $200,000 is $30,000, NII is $60,000, and she owes 3.8% × $30,000 = $1,140. The exchange deferred the tax for five years and let her control the year she triggered it — but it did not erase it.

Which Situation Applies to You?

The right read depends on the kind of annuity you hold and what you plan to do. Use this to find your path.

You own a nonqualified annuity (bought with after-tax dollars) and want to switch contracts → A 1035 exchange defers your gain and avoids NIIT this year. Read the worked example above and the mistakes section below.
You own a qualified annuity inside an IRA, 401(k), or 403(b) → Distributions from these are generally not net investment income at all, per the Ameriprise NIIT guide, so NIIT is rarely your concern; use a trustee-to-trustee transfer, not a 1035 exchange.
Your MAGI is comfortably below the threshold → Even a taxable withdrawal may carry zero NIIT; the exchange’s NIIT benefit may be small, though the deferral of ordinary income tax still helps.
You want only part of your annuity moved → A partial 1035 exchange is allowed but has special rules; see the partial-exchange trap below.
You are exchanging into long-term care coverage → A life or annuity contract can fund qualified LTC insurance tax-free under the Pension Protection Act, which can permanently avoid tax on the gain used.

Qualified vs. Nonqualified Annuities and the NIIT

Whether the 3.8% tax can ever touch your annuity depends entirely on whether it is qualified or nonqualified. This is the single most important distinction in the whole topic.

A nonqualified annuity is bought with after-tax dollars outside a retirement plan; its earnings are net investment income and can face the NIIT when distributed. A qualified annuity sits inside an IRA or employer plan; its distributions are taxed as ordinary income but are excluded from net investment income, so the NIIT does not apply to them. The table below shows how they differ on the points that decide your tax.

Annuity Feature	Nonqualified Annuity	Qualified Annuity (IRA/401(k)/403(b))
Funded with	After-tax dollars	Pre-tax (or Roth) dollars in a plan
Earnings count as net investment income?	Yes — subject to the 3.8% NIIT per the Ameriprise guide	No — plan distributions are excluded from NIIT
Tax-free transfer method	Section 1035 exchange	Trustee-to-trustee transfer or rollover
1099-R distribution code for NIIT flag	Code “D” used	Code “D” does not apply
Does a withdrawal raise MAGI?	Yes — and MAGI drives the NIIT	Yes — can push other income into NIIT range

A subtle point: even though a qualified distribution is not itself net investment income, it still raises your MAGI, which can push your other investment income (interest, dividends, capital gains) over the threshold and into the 3.8% tax. The Ketel Thorstenson CPA analysis notes that Section 1035 also has implications for qualified annuity assets, but the NIIT treatment of the distributions themselves still differs sharply. The action step: know your annuity type before you plan any move, because the wrong transfer method for the wrong type creates a taxable event.

Three Common Scenarios

These three patterns cover most real exchanges. Each is shown as the move and its tax result.

Scenario 1 — The clean insurer-to-insurer swap.

The Move	The Tax Result
Owner signs a 1035 exchange form; old insurer wires funds directly to the new insurer	No gain reported, no income, no NIIT this year; basis and gain carry over to the new contract

Scenario 2 — The accidental surrender.

The Move	The Tax Result
Owner cashes out the old annuity, deposits the check, then buys a new annuity	Full embedded gain is ordinary income now; the 3.8% NIIT can apply if MAGI exceeds the threshold

Scenario 3 — The exchange-then-withdraw.

The Move	The Tax Result
Owner does a proper 1035 exchange, then withdraws earnings years later	No tax at exchange; later withdrawal of earnings is ordinary income and may trigger 3.8% NIIT that year

Named Examples in Action

David, age 62, switches to a lower-fee annuity. David holds a nonqualified annuity with a $120,000 basis now worth $200,000. His advisor processes a 1035 exchange directly with the new insurer. David reports no income, owes no NIIT for 2025, and his $80,000 gain rides along with a carryover $120,000 basis. He saved the surtax by never touching the funds.

Linda, age 67, makes the classic mistake. Linda surrenders her $160,000 nonqualified annuity (basis $100,000), takes the check, and buys a new one a week later. Because the cash passed through her hands, it is a taxable surrender, not a 1035 exchange. Her $60,000 gain is ordinary income, her MAGI climbs over $200,000, and she owes 3.8% NIIT on the lesser amount — money a direct transfer would have saved.

Robert, age 70, controls his timing. Robert did a proper 1035 exchange three years ago. In 2025 he needs $40,000. By taking $20,000 in late December and $20,000 in early January, he keeps each year’s MAGI under his $200,000 threshold, owing $0 NIIT in both years — a legitimate spreading strategy.

Mistakes to Avoid

Each error below has a concrete cost.

Taking the cash yourself. Touching the funds turns a tax-free swap into a taxable surrender, exposing the full gain to income tax and possibly the 3.8% NIIT.
Confusing “defer” with “avoid.” Assuming the gain is gone forever leads to no withdrawal planning, and the NIIT can ambush you years later in a high-income year.
Losing your old basis records. Without proof of basis, the new insurer may treat more of a withdrawal as taxable gain than is correct, inflating both income tax and NIIT.
Botching a partial exchange. Withdrawing from either contract within 180 days of a partial 1035 exchange can cause the IRS to retroactively treat it as a taxable distribution, per Revenue Procedure 2011-38.
Exchanging an annuity into life insurance. This direction is not allowed tax-free and triggers a fully taxable surrender of the annuity gain.
Ignoring surrender charges. Investopedia notes you may still owe surrender charges on the old contract even though the exchange itself is tax-free.
Withdrawing in your highest-income year. Pulling earnings the same year you have large capital gains or a Roth conversion stacks your MAGI and maximizes the 3.8% tax.
Assuming a qualified annuity needs a 1035 exchange. IRA-based annuities move by trustee-to-trustee transfer; using the wrong method can create a taxable distribution.

Do’s and Don’ts

Do’s

Do route the transfer insurer-to-insurer, because direct movement is the only way to keep the gain deferred and the NIIT off this year’s return.
Do keep complete basis documentation, because you must prove your after-tax investment to limit future taxable gain.
Do model your MAGI before any withdrawal, because the NIIT depends entirely on your income in the withdrawal year.
Do confirm the new contract is genuinely better, because tax deferral is no reason to accept higher fees or a weaker insurer.
Do consider spreading withdrawals across tax years, because staying under the threshold can zero out the surtax.

Don’ts

Don’t surrender and repurchase, because that converts a tax-free swap into a taxable event with possible NIIT.
Don’t withdraw within 180 days of a partial exchange, because the IRS can retroactively tax it under Rev. Proc. 2011-38.
Don’t assume your state mirrors federal rules, because state income tax on annuity earnings varies even though the NIIT itself is federal-only.
Don’t ignore the carryover basis, because forgetting it leads to bad withdrawal planning.
Don’t rely on the insurer to calculate your NIIT, because issuers only flag the distribution and do not compute the tax.

Pros and Cons of Using a 1035 Exchange to Defer NIIT

Pros

Tax deferral, because no gain is reported in the exchange year, so no NIIT applies then.
Timing control, because you choose the later year you trigger the gain and can pick a low-MAGI year.
Product upgrade, because you can move to lower fees or better features without a tax penalty.
Estate flexibility, because deferring keeps more capital compounding inside the contract.
Compounding on pre-tax dollars, because the money that would have gone to tax keeps growing.

Cons

The tax is not erased, because the gain and the carryover basis follow you into the new contract.
Possible surrender charges, because the old contract may still impose them, as Investopedia warns.
New surrender period, because the replacement annuity often starts a fresh schedule of charges.
Recordkeeping burden, because you must track basis across contracts for years.
Threshold creep risk, because the un-indexed NIIT thresholds make future taxation more likely.

Federal vs. State Treatment

The NIIT is a federal tax under IRC Section 1411, and no state imposes its own 3.8% Net Investment Income Tax. So when people ask “does my state add a NIIT?” the honest answer is no — there is no state version to worry about.

State income tax on annuity earnings is a separate question, and it varies. A few states with no broad income tax — such as Florida, Texas, and Tennessee — do not tax annuity earnings at the state level at all, while most states tax the gain as ordinary income when you withdraw. A 1035 exchange defers state income tax on the gain the same way it defers federal tax, because there is no taxable event in the exchange year. The action step: check your own state’s rule on annuity distributions before you plan a withdrawal, since the federal NIIT and your state income tax are two different bills.

What to Do Next

Take these steps in order to keep your exchange clean and your NIIT planned.

Confirm your annuity type — nonqualified or qualified — because it decides whether NIIT can ever apply and which transfer method you must use.
Gather your basis records from the existing contract, because you will need them to limit future taxable gain.
Request a direct 1035 exchange in writing from the new insurer, and never accept a check made out to you.
Watch for Form 1099-R code “D”, which flags an annuity distribution that may be subject to NIIT, per the Ameriprise guide.
Plan the withdrawal year so your MAGI stays under your threshold where possible, then report any NIIT on Form 8960.
Call a CPA or tax attorney if you are doing a partial exchange, exchanging across contract types, or facing a large gain — situations where a single misstep can cost thousands.

This article is educational and is not a substitute for personalized advice from a licensed CPA, tax attorney, or financial professional for your specific situation.

Frequently Asked Questions

Does a 1035 exchange avoid the 3.8% NIIT on annuity gains? No. It defers the NIIT. A proper 1035 exchange reports no income, so no NIIT applies in the exchange year, but your gain and basis carry over and can face the 3.8% tax when you later withdraw earnings.

Are nonqualified annuity earnings subject to the NIIT? Yes. For tax year 2025, distributions of earnings from nonqualified annuities are net investment income and can face the 3.8% tax once your MAGI tops your filing-status threshold, as the IRS confirms.

Are IRA or 401(k) annuity distributions subject to the NIIT? No. Distributions from qualified plans like IRAs, 401(k)s, and 403(b)s are excluded from net investment income, so the 3.8% NIIT does not apply to them — though they still raise your MAGI.

What are the 2025 NIIT income thresholds? $200,000 for single or head of household, $250,000 for married filing jointly, $125,000 for married filing separately, and $250,000 for a qualifying surviving spouse. These are not indexed for inflation.

What is the NIIT rate? 3.8%. It applies to the lesser of your net investment income or the amount your modified adjusted gross income exceeds your threshold, under IRC Section 1411.

Will I get a tax form for an annuity distribution that may face NIIT? Form 1099-R with code “D.” Insurers use distribution code “D” on Form 1099-R to flag nonqualified annuity earnings that may be subject to the 3.8% tax. The insurer does not calculate the tax for you.

What form do I use to report and pay the NIIT? Form 8960. You figure and report the Net Investment Income Tax on IRS Form 8960, filed with your Form 1040.

Does a 1035 exchange itself create taxable income? No. A properly executed insurer-to-insurer 1035 exchange creates no taxable income, so there is nothing for the NIIT or income tax to apply to in the exchange year.

Can a partial 1035 exchange trigger the NIIT? Yes, if mishandled. Withdrawing from either contract within 180 days of a partial exchange can cause the IRS to treat it as a taxable distribution under Revenue Procedure 2011-38, exposing the gain to tax and possible NIIT.

Does my state charge its own 3.8% NIIT? No. The NIIT is federal-only under IRC Section 1411; no state imposes a separate version. Your state may still tax annuity earnings as ordinary income when you withdraw.

Can I exchange an annuity for life insurance tax-free? No. Section 1035 does not allow a tax-free exchange from an annuity into life insurance; attempting it triggers a fully taxable surrender of the annuity gain.

How can I legally reduce the NIIT on a future annuity withdrawal? Manage your MAGI. Spread withdrawals across tax years, time them for lower-income years, and avoid stacking large gains or Roth conversions in the same year, so you stay under your threshold.

Related reading