Full vs. Partial 1035 Exchange: Which Is Better? (w/Examples) + FAQs

This article reflects federal rules as of June 2026 and covers tax year 2025 and the 2026 filing season. State treatment is addressed separately below. Tax law changes — confirm current figures before you file or sign any exchange paperwork.

Quick Answer

Neither is universally better — it depends on your goal. A full 1035 exchange moves your entire annuity or policy tax-free into a new one, ending the old contract. A partial exchange moves only part, keeping both contracts alive. For tax year 2025, both defer all gain if done correctly.

A 1035 exchange lets you swap one annuity, life insurance policy, or long-term care contract for another without paying tax on the gain you have built up, under Internal Revenue Code Section 1035. The choice between full and partial is rarely about which is “better” in the abstract — it turns on whether you want to keep a valuable rider, preserve part of an old contract, or simply move everything to a cheaper, stronger product.

The stakes are real and the timing is tight. A botched partial exchange can convert a tax-free move into a fully taxable distribution plus a 10% early-withdrawal penalty if you are under 59½, and a full exchange of an annuity still inside its surrender period can cost thousands in charges. According to LIMRA, U.S. annuity sales topped a record $430 billion in 2024, and a large share of that money moved through 1035 exchanges — which means millions of people face this exact decision each year.

Here is what you will learn:

• 🔍 The exact difference between a full and partial 1035 exchange, in plain English
• ⚖️ A decision aid that matches your situation to the right type of exchange
• 💵 Fully worked dollar examples showing the math for basis, gain, and the 180-day trap
• 🚫 The seven costliest mistakes that turn a tax-free swap into a taxable event
• ✅ A clear “what to do next” checklist with forms, deadlines, and when to call a pro

What a 1035 Exchange Actually Is

A 1035 exchange is a tax-free swap of one insurance-based contract for another “like-kind” contract. The name comes from Section 1035 of the tax code, which says no gain or loss is recognized when you trade certain contracts for certain others. Tax-free here means tax-deferred — you do not pay tax now, but the gain follows you into the new contract through something called your cost basis.

Your cost basis is the money you put in that has already been taxed — usually your premiums. Your gain is the contract’s current value minus that basis. In a normal cash-out, the gain is taxable as ordinary income. In a 1035 exchange, the gain rides along untaxed into the new contract, and you only owe tax later when you actually pull money out.

The rule exists for a simple reason. As the IRS explains in Revenue Procedure 2011-38, Section 1035 protects people “who have merely exchanged one insurance policy for another better suited to their needs.” You did not cash out and pocket the money — you stayed invested in insurance — so Congress decided you should not be taxed for upgrading.

The consequence of doing it wrong is steep. If your exchange fails to qualify, the entire gain becomes taxable ordinary income in the year of the exchange. If you are under 59½, you may also owe a 10% early-withdrawal penalty on the taxable part under Section 72. A common misconception is that any annuity-to-annuity move is automatically tax-free; it is not — taking a check yourself or breaking the rules below can blow up the tax shelter. What you should do: route every exchange directly between insurers (a “direct” transfer), never as a check made out to you.

Which Contracts Qualify

Not every swap is allowed, and the direction matters. Under Section 1035 and the Pension Protection Act, the eligible “like-kind” moves are limited and one-directional in places. Life insurance can go to new life insurance, an annuity, or a qualified long-term care (LTC) policy. A non-qualified annuity can go to another annuity or to qualified LTC — but never to life insurance. Qualified LTC can only go to qualified LTC. An endowment can go to an annuity, LTC, or another endowment.

The consequence of getting direction wrong is total: an annuity-to-life-insurance “exchange” simply does not qualify, so the whole gain is taxed immediately. A frequent misconception is that because life insurance can become an annuity, the reverse must also work — it does not. What to do: confirm your specific swap appears in the allowed table below before you sign anything, and ask the receiving insurer to verify it accepts the exchange.

1035 Move (From → To)	Allowed Tax-Free?
Life insurance → Life insurance, annuity, or qualified LTC	Yes
Non-qualified annuity → Annuity or qualified LTC	Yes
Non-qualified annuity → Life insurance	No
Qualified LTC → Qualified LTC	Yes
Endowment → Annuity, LTC, or endowment	Yes

Full 1035 Exchange Explained

A full 1035 exchange moves 100% of your old contract’s value into a new contract, and the old contract is surrendered and closed. Your entire cost basis carries over to the new contract, and the deferred gain rides along with it. This is the clean, simple choice when you want to leave an old product entirely — say, to escape high fees, a weak insurer, or an outdated annuity with no living benefits worth keeping.

The “why” matters here. A full exchange gives you one combined contract to manage, one statement, and one set of rules going forward. The consequence of choosing it when you should have kept part of the old contract is that you permanently lose any valuable rider — like a guaranteed lifetime withdrawal benefit (GLWB) or an enhanced death benefit — that was attached to the original.

A real-world example: David, age 64, holds a $250,000 fixed annuity with a $150,000 basis at a 3% insurer crediting rate, and a competitor offers 5.4% with no living-benefit rider he cares about. A full 1035 exchange moves the whole $250,000 tax-free; his $150,000 basis and $100,000 deferred gain both transfer, and he owes nothing now. A misconception David must avoid is thinking the move resets his tax clock favorably — it does not change his basis, and per Bankrate it usually restarts the surrender period on the new contract. What David should do: confirm his old annuity is past its surrender period before moving.

Partial 1035 Exchange Explained

A partial 1035 exchange moves only a portion of your old contract’s value into a new contract, and both contracts stay open. Under current IRS guidance, your after-tax basis is split pro-rata — proportionally — between the old and new contracts based on the percentage of value you transfer. Move 40% of the value, and 40% of the basis follows.

This is the tool of choice when the old contract has something worth keeping. The most common reason is a rich rider — a GLWB, a high guaranteed death benefit, or a favorable crediting formula — that you would forfeit by surrendering the whole thing. The consequence of doing a partial exchange and then mishandling withdrawals is severe, and it is the single biggest trap in this entire topic, covered in detail below.

A real-world example: Maria, age 67, owns a $200,000 variable annuity with a $120,000 basis and a death-benefit rider she wants to keep on $100,000. She does a partial 1035 exchange of $100,000 (50% of value) into a low-cost fixed annuity. Per the pro-rata rule, 50% of her basis — $60,000 — moves with it, leaving $60,000 basis on the old contract. Both contracts stay tax-deferred, and she keeps the rider on the half she left behind.

The 180-Day Aggregation Rule

The 180-day rule is the partial exchange’s landmine. Under Revenue Procedure 2011-38, a partial annuity exchange is tax-free only if no amount — other than annuity payments over 10+ years or for life — is withdrawn from either the old or the new contract during the 180 days beginning on the transfer date. The IRS shortened this window from 12 months to 180 days, effective for exchanges on or after October 24, 2011.

The consequence of breaking it is brutal. If you take a withdrawal from either contract inside that 180-day window, the IRS can recharacterize the whole partial exchange as a taxable distribution, taxing the gain as ordinary income and adding a 10% penalty if you are under 59½. A widespread misconception, flagged by advisors at ICFS, is that only the new contract is frozen — in fact neither contract can have a withdrawal in those 180 days. What to do: mark the 180th day on your calendar and take no withdrawals from either contract until it passes, unless the withdrawal is a true lifetime annuity payment.

Which Situation Applies to You?

The right answer depends entirely on what you are trying to protect or escape. Use the branches below to find your fit, then read the matching section above.

• You want to leave a bad contract entirely (high fees, weak insurer, no rider worth keeping) → a full exchange is almost always cleaner and simpler.
• You have a valuable rider on the old contract (GLWB, enhanced death benefit) → a partial exchange lets you keep the rider on what stays behind.
• You need cash soon (within 6 months) → lean toward a full exchange, because a partial exchange freezes withdrawals from both contracts for 180 days.
• You want to diversify (split between a fixed and a variable annuity, or two insurers) → a partial exchange spreads the money while deferring all gain.
• You are funding long-term care → either type can feed a qualified LTC policy, but a series of partial exchanges is often used to pay annual LTC premiums tax-free.
• You are under 59½ → both work, but the 10% penalty risk on a botched move is higher, so the direct-transfer and 180-day rules matter even more.

Worked Example: Full vs. Partial Side by Side

Numbers make the choice concrete. Assume Susan, age 70, owns a non-qualified annuity worth $300,000 with a $180,000 cost basis (so $120,000 of deferred gain). She is comparing a full exchange into a new annuity against a partial exchange of one-third of the value.

In a full exchange, all $300,000 moves tax-free. The entire $180,000 basis transfers, and the entire $120,000 gain rides along. Susan owes $0 today. The old contract closes, and any rider on it is gone.

In a partial exchange of $100,000 (one-third of the $300,000 value), the pro-rata rule splits the basis. One-third of the $180,000 basis — $60,000 — moves to the new contract, and $120,000 of basis stays on the old contract. Both stay tax-deferred, and Susan owes $0 today as long as she takes no withdrawal from either contract for 180 days. If she pulls $20,000 from the old contract on day 90, the IRS can treat the gain portion of that partial exchange as taxable income — a costly, avoidable error.

Exchange Decision	Tax and Basis Result
Full exchange of $300,000	$180,000 basis and $120,000 gain both transfer; $0 tax now; old rider lost
Partial exchange of $100,000 (no early withdrawal)	$60,000 basis moves, $120,000 basis stays; $0 tax now; old rider kept
Partial exchange of $100,000 (withdrawal within 180 days)	Gain can become taxable ordinary income; 10% penalty if under 59½

Forms, Timing, and Costs

A 1035 exchange is reported on Form 1099-R, which you receive after the move. The insurer enters the gross amount in Box 1, shows $0.00 taxable in Box 2a, and marks distribution code 6 in Box 7, which the IRS uses to flag a tax-free Section 1035 exchange. Per Fidelity, the move is not taxable but still must be reported. A same-company, contract-for-contract exchange may not generate a 1099-R at all if the insurer keeps adequate basis records.

The process is initiated by the receiving insurer using a 1035 exchange/transfer form, and the money moves directly between companies — you never touch it. Timing varies widely: some carriers finish in 1 to 5 weeks, while others, per the B&C Brokerage FAQ, take up to 90 days when paperwork moves by mail.

Costs are the part people underestimate. Surrender charges are the big one — many annuities carry a 5-to-10-year surrender period with penalties highest in year one and declining over time, and insurers rarely waive them for an exchange to a different company. The consequence of exchanging mid-surrender is a direct dollar loss; on a $250,000 annuity, a 6% surrender charge is $15,000 gone. What to do: ask your current insurer in writing for your exact surrender schedule and any 30-day penalty-free window before you start.

Mistakes to Avoid

Each error below carries a specific, avoidable cost.

• Taking the money as a check to yourself. This breaks the direct-transfer requirement, and the IRS treats it as a taxable distribution, not an exchange.
• Withdrawing from either contract within 180 days of a partial exchange. This can recharacterize the whole move as taxable gain plus a possible 10% penalty.
• Exchanging during the surrender period. You can lose thousands in surrender charges that wipe out any benefit of the new contract.
• Trying to exchange an annuity into life insurance. This direction is not allowed, so the entire gain becomes taxable at once.
• Changing the owner or insured. The owner and insured must stay the same, or the exchange fails and the gain is taxed.
• Exchanging a contract with a loan or in the surrender phase carelessly. A carried-over loan can trigger taxable boot, and you owe tax on that amount.
• Ignoring the new surrender period. A “free” exchange that restarts a 10-year surrender clock can lock you in and cost you flexibility for a decade.
• Forgetting state premium tax or conformity quirks. A few states impose costs or rules that change the math, covered below.

Pros and Cons of Each Type

Each point includes the “why” so you can weigh it against your own situation.

Full exchange — pros: simpler (one contract to manage); cleaner escape from a bad product (you leave fees and a weak insurer entirely); full basis transfers automatically (no pro-rata math); no 180-day withdrawal freeze (the partial rule does not apply to full surrenders into a new contract); easier reporting (one Form 1099-R with code 6).

Full exchange — cons: you lose every rider on the old contract (gone for good); you may restart a long surrender period (locked in again); surrender charges hit the whole balance (bigger dollar penalty); no diversification across products; you cannot keep a favorable legacy crediting rate.

Partial exchange — pros: you keep valuable riders on the portion left behind (real dollar value preserved); you can diversify across insurers or product types; you can fund LTC premiums in installments tax-free; you keep a legacy contract’s better terms; you defer all gain if rules are followed.

Partial exchange — cons: the 180-day rule freezes withdrawals from both contracts (liquidity risk); pro-rata basis splitting adds complexity (easy to miscalculate); two contracts mean two sets of fees and statements; higher risk of a recharacterization error; not every carrier accepts partial exchanges smoothly.

Federal vs. State Treatment

Start with the federal rule: a properly executed 1035 exchange defers all gain at the federal level, full or partial, under Section 1035. That is the baseline for every U.S. taxpayer.

Does my state follow this? In most states, yes — the great majority conform to the federal income-tax treatment of 1035 exchanges, so a tax-free federal exchange is also tax-free for state income tax. Do not assume, though. A handful of states impose a premium tax on annuity contracts that can apply when money lands in a new annuity, and state conformity to federal definitions is not automatic. The consequence of guessing is an unexpected state tax bill on a move you thought was fully free. What to do: confirm your state’s treatment with your state department of revenue or insurance, and ask the receiving insurer whether a state premium tax applies to your contract.

What to Do Next

Follow these steps in order before you commit to any exchange.

1. Request your current contract’s surrender schedule and basis figures in writing from the existing insurer.
2. Decide your goal — escape a bad product (lean full) or keep a rider (lean partial) — using the decision aid above.
3. Have the receiving insurer initiate the 1035 transfer so the money moves directly, never to you.
4. If partial, calendar the 180th day and take no withdrawals from either contract until it passes.
5. Keep the Form 1099-R (code 6) for your records and confirm Box 2a shows $0.00 taxable.
6. Call a CPA or fee-only advisor if your contract has a loan, you are under 59½, the dollars are large, or you are unsure the swap qualifies.

This article is educational and is not a substitute for advice from a licensed tax or financial professional for your specific situation. A move involving a contract loan, an under-59½ owner, a sizable gain, or an estate plan is complex enough to justify a paid CPA, tax attorney, or fee-only financial advisor — who will verify the swap qualifies, run the basis math, and time the transfer to avoid surrender charges and the 180-day trap.

Frequently Asked Questions

Is a 1035 exchange taxable?

No. A properly executed 1035 exchange is tax-free for tax year 2025; the gain defers into the new contract instead of being taxed. It is reported on Form 1099-R with code 6 and $0 taxable in Box 2a.

Can I do a partial 1035 exchange?

Yes. You can transfer part of an annuity’s value tax-free under Revenue Procedure 2011-38. Your basis splits pro-rata between contracts, and you must avoid withdrawals from either contract for 180 days.

What is the 180-day rule for partial exchanges?

No withdrawals for 180 days. After a partial annuity exchange, taking money from either the old or new contract within 180 days can make the move taxable, plus a 10% penalty if you are under 59½.

How is basis split in a partial exchange?

Pro-rata by value transferred. If you move 40% of the contract’s value, 40% of your cost basis moves with it. The rest of the basis stays on the original contract.

Can I exchange an annuity for life insurance?

No. Section 1035 does not allow an annuity-to-life-insurance exchange. The reverse — life insurance to an annuity — is allowed, but not the other direction.

Does a 1035 exchange avoid surrender charges?

No. Surrender charges from your old contract usually still apply, and insurers rarely waive them for an exchange to a different company. Check your surrender schedule first.

How long does a 1035 exchange take?

Roughly 1 to 5 weeks, sometimes up to 90 days. Timing depends on the carriers and whether paperwork moves electronically or by mail. The receiving insurer initiates the transfer.

Can I exchange an annuity to pay for long-term care?

Yes. Since the Pension Protection Act, a non-qualified annuity or life policy can be exchanged tax-free into a qualified long-term care insurance contract under Section 1035.

Do I owe state tax on a 1035 exchange?

Usually no. Most states conform to the federal tax-free treatment. A few states levy a premium tax on annuities, so confirm with your state revenue or insurance department.

What form reports a 1035 exchange?

Form 1099-R with distribution code 6. Box 1 shows the gross amount, Box 2a shows $0.00 taxable, and Box 7 shows code 6 to flag the tax-free Section 1035 exchange.

Can I exchange between two different insurance companies?

Yes. Cross-company 1035 exchanges are common and stay tax-free, but the money must transfer directly between insurers — you cannot receive a check made out to you.

Is a full or partial exchange better for keeping a rider?

Partial is better. A partial exchange lets you keep a valuable rider, like a guaranteed lifetime withdrawal benefit, on the portion you leave in the original contract.