Does a 1035 Exchange Defer or Eliminate the Tax? (w/Examples) + FAQs

Quick Answer

A 1035 exchange defers the tax — it does not eliminate it. For tax year 2025, swapping one qualifying life insurance, annuity, or endowment contract for another postpones the gain instead of erasing it. Your old cost basis carries to the new contract, so the tax waits until you withdraw or surrender.

A 1035 exchange (named for Section 1035 of the Internal Revenue Code) lets you trade one insurance or annuity contract for a “like-kind” replacement without paying tax today on the built-up gain. The catch most people miss: the gain does not vanish. It rides along on the new contract through a rule called carryover basis, and the IRS collects later when money actually leaves the policy. Treating a deferral as an elimination is the costliest myth in this corner of the tax code.

The timing matters because the wrong move triggers an immediate, fully taxable event — ordinary income, not the lower capital-gains rate. With more than 100 million annuity contracts in force in the United States according to the American Council of Life Insurers, millions of owners face this exact decision each year, often while switching to a lower-fee product or a stronger insurer. Get the mechanics right and you keep your money compounding; get them wrong and you hand the IRS a bill you could have avoided.

Here is what you will learn:

• 🔁 Why a 1035 exchange defers tax through carryover basis instead of wiping it out
• 💀 The one situation where deferral can turn into true elimination — and the one where it never does
• 🧮 Fully worked dollar examples showing exactly how the basis follows the contract
• ⚠️ The prohibited swaps, the “boot” trap, and the 180-day partial-exchange rule that create surprise tax
• 🧭 A step-by-step plan for doing the exchange right, including the form, the deadline, and when to call a pro

This article is educational and not a substitute for advice from a licensed tax professional, CPA, or insurance specialist for your specific situation. It reflects federal rules as of June 2026 and covers tax year 2025. Tax law changes — confirm current figures before you act.

Defer vs. Eliminate: The Core Distinction

The whole question turns on one word: defer. To defer a tax means to push it into the future; the liability still exists, it just has not come due. To eliminate a tax means the liability is gone for good — it will never be owed by anyone. A 1035 exchange does the first, almost never the second.

Section 1035(a) says “no gain or loss shall be recognized” on a qualifying exchange. The key word is recognized, not eliminated. In tax language, an unrecognized gain is a gain the IRS chooses not to tax yet — it is parked, not pardoned. The mechanism that parks it is carryover basis under Section 1031(d), which Section 1035 borrows.

Here is the consequence in plain terms. Your cost basis — the total premiums you paid, minus any tax-free withdrawals — moves from the old contract to the new one unchanged. The gain (contract value minus basis) moves too. So the day after your exchange, you are sitting on the exact same embedded gain you had the day before, on a new contract. Nothing was forgiven. The tax meter simply keeps running on the replacement.

A common misconception is that “tax-free exchange” means “tax-free forever.” It does not. It means tax-free at the moment of the swap. The bill arrives later, when you surrender the contract, take a withdrawal of gain, or (for an annuity) start income payments. What you should do about it: treat the exchange as a pause button, not a delete key, and keep records of your original basis so you can prove it years later.

How Carryover Basis Actually Works

Carryover basis is the engine that makes a 1035 exchange a deferral. When you exchange Contract A for Contract B, the IRS does not let you “reset” your cost basis to the new contract’s current value. Instead, Contract B inherits Contract A’s basis.

Why this matters: if you could reset basis, the gain really would disappear, and that would be elimination. The tax code blocks that by forcing the old, lower basis to follow you. The Thrivent explainer on 1035 exchanges confirms that preserving the original basis is the defining feature of the transaction.

The consequence of a missing basis record is brutal. If you cannot prove what you paid, the insurer and the IRS may treat far more of your withdrawal as taxable gain than is fair. Annuities are taxed last-in, first-out (LIFO), meaning gains come out first and are taxed as ordinary income before you ever touch your tax-free principal.

A frequent misunderstanding is that the new insurer “knows” your basis automatically. Often it does, because basis transfers with the paperwork — but errors happen, especially across multiple past exchanges. What you should do: request a written basis confirmation from both the old and new carriers, and keep every annual statement.

A Fully Worked Example: The Annuity Swap

Numbers make this concrete. Meet Maria, age 58, who owns a non-qualified deferred annuity in tax year 2025.

Maria’s Annuity Detail	Amount
Total premiums paid (cost basis)	$60,000
Current contract value	$90,000
Embedded gain	$30,000

Maria is unhappy with her contract’s fees and wants a better annuity at a new insurer. She has two paths.

Path 1 — Cash out, then rebuy. Maria surrenders her annuity for $90,000. The $30,000 gain is taxed as ordinary income. At a 24% federal bracket, that is $7,200 in federal tax for 2025, plus possible state tax. Because she is under 59½, she may also owe a 10% early-distribution penalty on the gain — another $3,000, per IRS rules under Section 72. She nets about $79,800 to reinvest.

Path 2 — 1035 exchange. Maria directly exchanges her $90,000 contract for a new $90,000 annuity. She recognizes $0 of gain now. Her $60,000 basis carries to the new contract, and her $30,000 gain is still embedded. All $90,000 keeps compounding. No tax, no penalty — today.

The deferral does not erase the $30,000. When Maria eventually withdraws gain or annuitizes, that gain is taxed as ordinary income then. The 1035 exchange let her keep an extra $10,200 working for her instead of going to the IRS years early — the entire value of deferral is the growth on money you did not have to send away.

The One Way Deferral Becomes True Elimination

There is exactly one common scenario where the deferred tax can disappear — and it applies to life insurance, not annuities. If you hold a life insurance contract until the insured dies, the death benefit generally passes to your beneficiaries income-tax-free under Section 101(a). The gain that was deferred inside the policy is never taxed as income to anyone.

This is why “don’t die with an annuity, die with life insurance” is a planning maxim. A 1035 exchange that moves you into a permanent life policy you keep until death can convert a lifetime of deferral into permanent elimination of the income tax on the gain. The deferral and the death benefit work together.

The consequence of misreading this: people assume annuities get the same break. They do not. As the annuity.org guide on inheriting an annuity explains, an inherited non-qualified annuity gets no step-up in basis. The deferred gain becomes the heir’s taxable income, taxed as ordinary income under LIFO rules.

A widespread misconception is that all inherited investments get a step-up that wipes out gain at death. That is true for stocks and real estate, not for annuities. What you should do: if elimination at death is your goal, talk to an advisor about whether life insurance — not an annuity — fits, and confirm beneficiary designations are current.

Annuity vs. Life Insurance at Death

The difference at death is the single most important nuance behind your title’s “eliminate” question. The two contract types end very differently.

What Happens at the Owner’s Death	The Tax Result
Permanent life insurance held to death	Death benefit is generally income-tax-free to beneficiaries; deferred gain is eliminated for income-tax purposes
Non-qualified deferred annuity held to death	No step-up in basis; deferred gain becomes the beneficiary’s ordinary income, taxed under LIFO

The Wilder Wealth Strategies analysis confirms that non-qualified annuities follow LIFO at death, so gains come out first and are taxed as ordinary income — never the lower long-term capital-gains rate. A $100,000 annuity that grew from a $40,000 basis hands the heir a $60,000 taxable event spread across the payout period.

The consequence is a hidden “tax time bomb” for heirs who expected a clean inheritance. What you should do: if you own a large gain inside an annuity and your goal is to pass money efficiently, ask a professional whether keeping it, exchanging it, or repositioning it best fits your estate plan — because the annuity’s gain will be taxed to someone.

Which Situation Applies to You?

The right answer depends on what you own and what you want. Use these branches to find your path.

• You own an annuity with a gain and want a better contract: A 1035 exchange defers your gain. Read the annuity example and the partial-exchange rules below.
• You own life insurance you plan to keep until death: A 1035 exchange into a better permanent policy can turn deferral into elimination. Read the death-benefit section.
• You own an annuity and want life insurance instead: You cannot do this as a 1035 exchange — it is prohibited. Read the prohibited-exchanges section.
• You have a loan on your old life policy: Watch for “boot.” Read the boot section before you act.
• You want to keep your old contract and move only part of it: You need a partial exchange. Read the 180-day rule section.
• You inherited a contract: Beneficiaries have limited 1035 rights and strict distribution rules. Read the FAQs on inherited contracts.

What Exchanges Are Allowed — and What Is Banned

Section 1035 only protects “like-kind” swaps, and the rules run one direction for annuities. Knowing the allowed grid prevents an accidental fully taxable surrender.

Per IRS guidance and Section 1035(b), the permitted exchanges are:

• Life insurance → life insurance
• Life insurance → annuity
• Life insurance → endowment
• Life insurance → qualified long-term care (LTC) insurance
• Annuity → annuity
• Annuity → qualified LTC insurance
• Endowment → annuity (and certain endowment-to-endowment swaps)

The critical prohibited move: annuity → life insurance is not allowed. The LegalClarity overview explains the IRS blocks this because it would let deferred, taxable annuity gain slip into a tax-free death benefit — converting deferral into elimination without ever paying tax.

The consequence of attempting a banned swap is a full surrender: your entire annuity gain becomes taxable ordinary income immediately, plus a possible 10% penalty if you are under 59½. A common misconception is that “any insurance product can swap for any other.” It cannot. What you should do: confirm the direction of your swap before signing, and if you want to move from an annuity toward life coverage, ask your advisor about legal alternatives like withdrawals funding a separate policy.

The Boot Trap: When Part of a “Tax-Free” Exchange Is Taxed

“Boot” is any non-like-kind value you receive in an exchange — usually cash or the relief of a policy loan. Boot is taxable even inside an otherwise tax-free 1035 exchange, up to the amount of your gain.

The most common boot trap involves policy loans on life insurance. If you have an outstanding loan on your old policy and that loan is discharged (paid off and not carried to the new policy) during the exchange, the BSMG analysis of 1035 exchanges with loans explains that the lesser of the loan amount or the policy gain becomes currently taxable as boot.

Here is a quick worked illustration. James exchanges a life policy with a $25,000 gain and a $15,000 loan he does not carry over. The discharged $15,000 loan is boot, and because it is less than his $25,000 gain, $15,000 is taxable to him now. Had he carried the loan to the new policy, the exchange could have stayed fully tax-free.

A frequent misconception is that loans “don’t count” because no cash changed hands. The IRS treats loan relief as economic benefit. What you should do: ask the new insurer to carry over the loan to the replacement contract whenever possible, and never assume a loaned policy exchanges cleanly.

Partial Exchanges and the 180-Day Rule

You do not have to exchange your whole contract. A partial 1035 exchange moves only part of an annuity’s value to a new contract, and the basis is split proportionally between the two.

The trap is timing. Under Revenue Procedure 2011-38, if you take a withdrawal from either contract within 180 days of a partial exchange, the IRS can collapse the two contracts back into one and re-tax the transaction under general LIFO principles. What looked tax-free becomes partly taxable.

A worked example shows the split. Linda has a $100,000 annuity with a $40,000 basis (40% basis ratio). She partially exchanges $50,000 into a new annuity. Her basis splits 40/60 proportionally: the new $50,000 contract carries $20,000 of basis, and the old $50,000 remainder keeps $20,000. If she touches either within 180 days, she risks ordinary-income tax on gains pulled out first.

There is one safe exception: payments taken as a life annuity, or as a stream over 10 years or more, are not caught by the 180-day rule, per Rev. Proc. 2011-38. What you should do: after a partial exchange, do not withdraw from either contract for at least 180 days unless you are taking qualifying lifetime or 10-year-plus payments — and mark the date on your calendar.

Surrender Charges: What a 1035 Exchange Does NOT Avoid

A 1035 exchange defers tax, but it does not erase surrender charges. These are two separate costs, and confusing them is expensive.

A surrender charge is a penalty the insurer imposes for leaving a contract early, often within the first 5 to 10 years and sometimes starting near 7% to 10% of value. The Accounting Insights review of surrender charges confirms a 1035 exchange does not waive them — moving to a new contract still counts as leaving the old one.

The consequence: you could legally defer all your tax and still lose thousands to a surrender charge. On a $90,000 annuity with a 6% surrender charge, that is $5,400 gone, regardless of the tax savings. What you should do: check your contract’s surrender schedule before exchanging, and if you are near the end of the surrender period, consider waiting until it expires so the exchange costs you nothing in penalties.

Step-by-Step: How to Do a 1035 Exchange Correctly

Doing this right is about one rule above all: the money must move directly between insurers. If a check is made payable to you, the IRS treats it as a taxable distribution, and the deferral is lost.

1. Confirm the swap is allowed. Match your move to the permitted grid above. Annuity → life insurance is banned.
2. Check costs first. Review surrender charges on the old contract and any new contract’s fees and surrender schedule.
3. Gather your basis records. Pull statements showing total premiums paid and any prior withdrawals so basis transfers correctly.
4. Open the new contract and complete the new insurer’s 1035 exchange request form (often called an “absolute assignment” or “exchange/transfer” form).
5. Insist on a direct transfer. The funds go insurer-to-insurer; you never take possession. This is the non-negotiable step.
6. Verify the boot and loan handling. If a policy loan exists, arrange to carry it over.
7. Watch the 180-day window if it is a partial exchange.
8. Keep the Form 1099-R you receive, typically coded “6” for a 1035 exchange, and confirm it shows no taxable amount.

Timing: a clean exchange usually takes 2 to 6 weeks. Cost: DIY through the new insurer is typically free beyond surrender charges; a fee-only advisor review may run a few hundred dollars and is worth it for large contracts.

Federal vs. State Tax Treatment

Section 1035 is a federal rule. The good news is that most states with an income tax conform to the federal treatment of 1035 exchanges, so a qualifying exchange that defers federal tax usually defers state tax too.

Never assume, though — conformity varies, and a few states decouple from specific federal provisions. States with no income tax, such as Florida, Texas, and Washington, raise no state income-tax issue on the gain at all. What you should do: confirm your state’s treatment with your state department of revenue or a local CPA before a large exchange, especially if you have moved states since buying the contract.

The consequence of guessing is a surprise state tax bill on a gain you thought was fully deferred. A common misconception is that “tax-free federally” automatically means “tax-free in my state.” It usually does, but the burden is on you to verify your state follows federal law.

Mistakes to Avoid

• Taking the check yourself. A distribution paid to you, not the new insurer, is fully taxable and breaks the exchange.
• Attempting an annuity → life insurance swap. It is prohibited; the result is a full, taxable annuity surrender.
• Ignoring a policy loan. A discharged loan becomes taxable boot up to your gain amount.
• Withdrawing within 180 days of a partial exchange. The IRS can collapse the contracts and tax the gain.
• Losing your basis records. Without proof of basis, more of your money may be taxed as gain later.
• Forgetting surrender charges. You can defer all the tax and still lose thousands in penalties.
• Assuming the gain is gone. It is deferred, not eliminated; the bill arrives on withdrawal or surrender.
• Changing the owner or insured. The owner and insured generally must stay the same, or the exchange can fail and become taxable.

Do’s and Don’ts

• Do move funds directly between insurers, because any check to you triggers tax.
• Do keep your original cost-basis records, because you may need them years later to limit taxable gain.
• Do confirm the swap direction is permitted, because a banned exchange becomes a full taxable surrender.
• Do check surrender charges first, because deferral does not waive them.
• Do wait 180 days after a partial exchange before withdrawing, because early withdrawals can void the tax break.
• Don’t assume a 1035 exchange erases the gain, because it only postpones it.
• Don’t ignore policy loans, because loan relief is taxable boot.
• Don’t change the contract owner during the swap, because mismatched ownership can disqualify it.
• Don’t rely on memory for basis, because errors across multiple past exchanges compound.
• Don’t skip professional review on large contracts, because one mistake can cost thousands.

Pros and Cons

• Pro — Tax deferral. You keep the full contract value compounding instead of sending gain to the IRS early.
• Pro — Upgrade flexibility. You can move to lower fees, better features, or a stronger insurer without a taxable event.
• Pro — Basis preservation. Your original investment is protected and follows the new contract.
• Pro — Possible elimination via life insurance. Held to death, a life policy’s gain can escape income tax entirely.
• Pro — Partial moves allowed. You can reposition part of an annuity while keeping the rest.
• Con — Tax is only postponed. The gain remains taxable on future withdrawal or surrender.
• Con — Surrender charges still apply. The exchange does not waive early-exit penalties.
• Con — Boot can be taxable. Discharged loans or cash received are taxed up to the gain.
• Con — Strict rules. A check to you, a banned swap, or an owner change can blow the deferral.
• Con — New surrender period. The replacement contract often starts a fresh surrender-charge clock.

What to Do Next

1. Identify your goal — lower fees, better features, or eliminating tax at death (which points to life insurance, not an annuity).
2. Pull your basis records and current contract value from your existing insurer.
3. Check your surrender schedule and decide whether to wait until the penalty period ends.
4. Confirm your swap is permitted and that the funds will move insurer-to-insurer.
5. Complete the new insurer’s 1035 exchange form and request written basis confirmation.
6. Calendar the 180-day window if it is a partial exchange.
7. Call a CPA or fee-only advisor before exchanging any large contract, one with a loan, or any annuity you plan to leave to heirs — this is exactly when professional help pays for itself.

Frequently Asked Questions

Does a 1035 exchange eliminate taxes? No. A 1035 exchange defers tax by carrying your old cost basis to the new contract. The gain is postponed, not erased, and becomes taxable when you withdraw, surrender, or annuitize.

Is a 1035 exchange completely tax-free? Yes — but only at the moment of the swap. No gain is recognized when you exchange qualifying contracts directly. The deferred gain stays embedded and is taxed later on withdrawal or surrender.

Can I 1035 exchange an annuity for life insurance? No. The IRS prohibits annuity-to-life-insurance exchanges. Attempting it triggers a full annuity surrender, taxing the entire gain as ordinary income, plus a possible 10% penalty if you are under 59½.

Does the gain ever truly disappear? Yes, in one case. Life insurance held until the insured’s death pays an income-tax-free death benefit under Section 101(a), eliminating the deferred income tax. Annuities get no such break.

Do inherited annuities get a step-up in basis? No. Non-qualified annuities receive no step-up at death. The deferred gain becomes the beneficiary’s ordinary income under LIFO rules, taxed as the money comes out.

What is “boot” in a 1035 exchange? Boot is non-like-kind value you receive, such as cash or relief of a policy loan. It is taxable up to the amount of your gain, even within an otherwise tax-free exchange.

Does a 1035 exchange avoid surrender charges? No. A 1035 exchange defers tax but does not waive surrender charges. Leaving an old contract early can still cost a percentage of value, often 6% to 10%.

What is the 180-day rule? A 180-day waiting period after a partial exchange. Withdrawing from either contract within 180 days lets the IRS combine them and re-tax the gain, except for qualifying lifetime or 10-year-plus payments.

Will I get a tax form for a 1035 exchange? Yes — usually a Form 1099-R coded “6.” It reports the exchange to the IRS and should show no taxable amount if the exchange qualified fully.

Can the check be sent to me to reinvest? No. The funds must move directly between insurers. A check payable to you is treated as a taxable distribution and destroys the deferral.

Do states follow the federal 1035 rule? Most do. States with an income tax generally conform, so the exchange defers state tax too. Confirm with your state revenue agency, since conformity is not guaranteed.

Is there a limit on how many 1035 exchanges I can do? No fixed limit. You may exchange repeatedly, but each new contract may start a fresh surrender-charge period, and basis must carry accurately through every swap.