Should You 1035 a Variable Annuity Into a Lower-Cost One? (w/Examples) + FAQs

This article reflects federal rules as of June 2026 and covers tax years 2025 and 2026. State premium-tax figures are as of 2025. Tax law changes often — confirm current figures with the IRS or a licensed professional before you act.

Quick Answer

Often, yes — a Section 1035 exchange lets you swap a high-fee variable annuity for a lower-cost one with no tax on your gains, as long as both contracts are annuities and you own both. But it backfires if you still owe surrender charges, lose a valuable income rider, or start a new surrender clock.

Why This Decision Matters Right Now

You bought a variable annuity years ago, and now you see the fees: a 1.25% mortality and expense charge here, a 0.30% admin fee there, and fund costs on top. Those layers can push your all-in cost past 2% or even 3% a year, which quietly eats your retirement savings. A Section 1035 exchange lets you move that money into a leaner annuity without paying tax today — but the wrong move can cost you a surrender penalty or a guaranteed income benefit you can never get back.

The stakes are real and the timing matters. Older contracts often carry an eight-year-or-longer surrender period, and FINRA warns that variable annuities can have surrender charges of eight years or more. If you exchange at the wrong time, you swap a known fee problem for a fresh penalty and a brand-new lock-up. According to Morningstar fee research, the average variable annuity still costs well over 2% a year all-in, so a switch to a 0.25%–0.65% contract can save a six-figure account thousands of dollars annually.

Here is what you will learn:

💸 How a 1035 exchange moves your gains tax-free — and the one mistake that makes it fully taxable.
⏳ How to spot a surrender charge or lost income rider before it wipes out your savings.
🧮 A full worked example showing the real dollars a lower-cost annuity saves you.
🗺️ Which situation fits you — taxable account, IRA, or a contract with a living benefit.
🏛️ How federal tax-free treatment works and when your state’s premium tax still applies.

What a 1035 Exchange Actually Is

A 1035 exchange is a tax-free swap of one insurance contract for a like-kind contract, named after Section 1035 of the Internal Revenue Code. In plain words, it lets you trade your old variable annuity for a new annuity without the IRS treating the move as a sale. Normally, cashing out an annuity means paying ordinary income tax on every dollar of gain. A 1035 exchange lets that gain ride into the new contract untouched.

The rule exists because Congress did not want to punish people for upgrading an insurance or annuity contract. The IRS confirms in Notice 2003-51 that an annuity-for-annuity swap defers the gain rather than erasing it. The consequence of ignoring the rule is steep: if you simply withdraw the cash and then buy a new annuity yourself, the IRS treats it as a taxable distribution, and you owe tax on the full gain plus a possible penalty.

Here is a mini-scenario. Tom, age 64, owns a variable annuity worth $200,000, with $80,000 of that being gain. If Tom cashes out, he reports $80,000 of ordinary income — possibly $17,600 or more in federal tax in a 22% bracket. If Tom instead does a proper 1035 exchange into a low-cost annuity, he reports $0 in tax and keeps the full $200,000 working for him.

A common misconception is that a 1035 exchange erases the tax bill forever. It does not. The gain stays embedded in the new contract and is taxed when you eventually withdraw it. What you should do: confirm the swap is a direct, insurer-to-insurer transfer, and never touch the money yourself.

Why “like-kind” matters

Section 1035 only protects swaps between matching contract types, and an annuity must go to an annuity. As Bankrate explains, the contracts must be like-kind, so a variable annuity can move into a fixed, fixed-indexed, or another variable annuity tax-free. You may exchange a life insurance policy into an annuity, but you may not go the other way — annuity to life insurance is a prohibited move.

The consequence of a wrong direction is a fully taxable event. The IRS held in Revenue Ruling 2007-24 that certain swaps fail Section 1035 when the form is wrong. What you should do: tell your new insurer in writing that you want a “1035 exchange,” not a withdrawal, so the paperwork is coded correctly from day one.

Which Situation Applies to You?

The right answer depends on where your annuity lives and what features it carries. Find your case below, then read the section that fits.

Your annuity is in a taxable (non-qualified) account. This is the classic 1035 case. The exchange protects your embedded gain, and the rest of this guide is written for you.
Your annuity is inside an IRA, 401(k), or 403(b). A 1035 exchange does not apply to you. NAPA confirms 1035 exchanges are only for non-qualified contracts, because money inside an IRA is already tax-deferred. You move it with a custodian-to-custodian transfer instead, which carries no tax if done directly.
Your contract has a guaranteed income or death-benefit rider. Slow down. A guaranteed minimum withdrawal benefit (GMWB) or guaranteed minimum income benefit (GMIB) can be worth more than the fee you would save. Read the rider section before you decide.
You are still inside the surrender period. Check your surrender schedule first. Exchanging now may trigger a charge that erases years of fee savings.

How Cost Basis Carries Over

Your cost basis is the money you already paid tax on — usually your original premiums. In a 1035 exchange, that basis carries over to the new annuity unchanged. The IRS ties the basis rule to Section 1031 in Notice 2003-51, so the new contract keeps the same basis as the old one, adjusted only for any cash you receive.

This matters because basis controls how much tax you owe later. If you invested $120,000 and the contract is now worth $200,000, your basis is $120,000 and your gain is $80,000. After the exchange, the new annuity still shows a $120,000 basis, so only the $80,000 gain is ever taxed on withdrawal. The consequence of botching the transfer is losing that basis tracking and risking double tax.

The “preserving a loss” trap

Sometimes a variable annuity is worth less than what you paid in, and that loss has real tax value. As Navy Mutual explains, a 1035 exchange preserves your original basis even after market losses. Maria, age 58, paid $150,000 into a variable annuity now worth $110,000. If she does a 1035 exchange, her $150,000 basis carries forward, so future gains are taxed only above $150,000.

But here is the subtlety many people miss. Once the basis exceeds the value, future growth is shielded until the account climbs back above $150,000. What you should do: if your annuity is underwater, weigh whether a 1035 exchange (to keep the high basis) or a full surrender (to possibly claim a loss) serves you better, and ask a CPA which path your facts support.

A Full Worked Example: The Real Dollars

Numbers make this decision clear, so here is a complete example you can copy.

Margaret, age 62, owns a non-qualified variable annuity worth $300,000. Her contract charges 2.30% all-in each year (1.25% mortality and expense, 0.30% admin, and 0.75% in fund costs). A low-cost variable annuity she is considering charges 0.55% all-in. Her surrender period ended two years ago, so she owes no surrender charge. Her basis is $180,000 and her gain is $120,000.

Step 1 — Old annual cost: $300,000 × 2.30% = $6,900 per year. Step 2 — New annual cost: $300,000 × 0.55% = $1,650 per year. Step 3 — Annual savings: $6,900 − $1,650 = $5,250 per year. Step 4 — Tax on the exchange itself: $0, because a proper 1035 exchange defers the $120,000 gain. Step 5 — Rough 10-year impact: at $5,250 a year saved (before compounding), Margaret keeps over $52,500 that would have gone to fees, and far more once that money keeps growing.

The lesson is that the fee gap, not the tax, is usually the prize. Margaret pays no tax to make the switch, and she stops the yearly bleed. What she should do next: confirm she is past her surrender period (she is), confirm she holds no rider she values, then start a direct 1035 transfer.

Three Common Scenarios

Below are the three situations most people face, with the likely outcome of each.

Scenario 1: Past the surrender period, no rider

Your Move	What Happens
1035 exchange to a 0.55% annuity	Tax-free swap, no surrender charge, full fee savings begin
Cash out and reinvest yourself	Full gain taxed now, plus a possible 10% penalty if under 59½
Do nothing	You keep paying 2%+ a year, costing thousands annually

Scenario 2: Still inside the surrender period

Your Move	What Happens
1035 exchange now	Tax-free on gain, but you owe a surrender charge of up to 7%
Wait until the surrender period ends	No charge, then exchange tax-free for full savings
Exchange into a contract that “absorbs” the charge	Often hidden in a new, longer surrender schedule — read closely

Scenario 3: Contract has a valuable income rider

Your Move	What Happens
1035 exchange away from the rider	You lose the guaranteed income base, which may exceed the fee savings
Keep the contract for the rider	You pay higher fees but keep the guarantee you paid for
Exchange to a new contract with a comparable rider	Rare and costly; compare guarantees carefully before moving

Surrender Charges: The Number-One Deal-Breaker

A surrender charge is a penalty the insurer charges if you pull money out during a set early period, and it can quietly destroy your fee savings. FINRA describes the surrender charge as a contingent deferred sales charge owed when you withdraw during the surrender period. These charges often start near 7% and decline each year, reaching zero after seven to 10 years.

The consequence of ignoring this is direct: a 7% charge on a $300,000 contract is $21,000, which can erase four years of fee savings in one stroke. Robert, age 60, exchanged a contract still in year three of its schedule and paid a 5% charge — $15,000 — to save $5,000 a year. He needed three years just to break even.

A common misconception is that a 1035 exchange avoids surrender charges. It does not. A 1035 exchange only avoids income tax; the insurer’s surrender charge is a separate contractual cost that still applies. What you should do: ask your current insurer for your exact surrender schedule and surrender value in writing, then compare the charge against your projected savings before you move.

Watch for a brand-new surrender clock

Even if your old surrender period is over, a new annuity often starts its own. FINRA’s investor guidance warns that new charges and longer surrender periods can apply to the replacement contract. So you can trade a contract you can finally access for one that locks you up for another eight years.

The consequence is reduced flexibility right when you may need income. What you should do: ask the new contract’s surrender schedule up front, and favor low-cost annuities with short or no surrender periods if liquidity matters to you in retirement.

Living Benefit Riders: Don’t Throw Away the Crown Jewel

Many older variable annuities carry guaranteed living benefit riders, and these can be worth far more than the fee you would save. A GMWB or GMIB guarantees an income base that may have grown well above your actual account value, especially if it locked in market highs. If you 1035 away, that guaranteed base usually vanishes.

The consequence can be enormous. Helen, age 70, has a $250,000 account value but a $400,000 guaranteed income base from a rider bought in 2008. Exchanging to save 1.5% in fees would forfeit $150,000 of guaranteed income value — a terrible trade. What she should do: keep the contract and use the rider, because the guarantee outweighs the fee savings.

A common misconception is that all old annuities are bad and should be dumped. Not true. Some legacy riders are richer than anything sold today. What you should do: ask your insurer for your current rider value and guaranteed income base in writing, and have a fee-only advisor compare it against the fee savings before you act.

The IRA Annuity: A 1035 Exchange Won’t Help You

If your annuity sits inside an IRA or other qualified plan, Section 1035 simply does not apply. As NAPA explains, 1035 exchanges cover only non-qualified contracts, because IRA money is already tax-deferred. There is no second layer of tax deferral to protect.

The good news is you do not need a 1035 exchange here. You can move an IRA annuity into a lower-cost investment with a direct custodian-to-custodian transfer, with no tax owed if done correctly. The consequence of doing it wrong — taking a check yourself — could be a taxable distribution and a possible 10% penalty if you are under 59½.

David, age 55, held a high-fee annuity inside his IRA. He did not need a 1035 exchange. He transferred the IRA directly to a low-cost provider, dodged the fees, and owed no tax. What you should do: if your annuity is in an IRA, ask for a direct transfer or trustee-to-trustee transfer, not a 1035 exchange.

Partial 1035 Exchanges

You do not have to move the whole contract. A partial 1035 exchange lets you transfer only part of an annuity into a new one, and the IRS confirmed in Revenue Ruling 2003-76 that a partial exchange is tax-free under Section 1035. Your basis splits proportionally between the old and new contracts.

The consequence of splitting matters for taxes. If you move 40% of a contract, 40% of your basis follows. Susan, age 65, moved $80,000 of her $200,000 annuity, so $48,000 of her $120,000 basis carried to the new contract. A common misconception is that you can cherry-pick which dollars move; you cannot, because basis allocates by percentage. What you should do: confirm the insurer codes it as a partial 1035 and watch the IRS aggregation rules, which can tax withdrawals from either contract within 180 days.

Mistakes to Avoid

These errors turn a smart move into a costly one.

Taking the cash yourself. As Oblivious Investor warns, do not liquidate then rebuy — that makes the whole gain taxable instead of deferred.
Ignoring the surrender charge. A 7% charge can erase years of fee savings and leave you worse off short-term.
Forfeiting a valuable rider. Dumping a rich GMWB or GMIB can cost more guaranteed income than any fee you save.
Forgetting the new surrender clock. A replacement contract can lock your money up for another eight-plus years.
Trying to 1035 an IRA annuity. It does not qualify, and a wrong transfer can trigger tax and a 10% penalty.
Mismatching contract types. An annuity cannot 1035 into life insurance, and a wrong direction is fully taxable.
Overlooking the 10% early-withdrawal penalty. SmartAsset notes the IRS adds a 10% penalty on gains before 59½ if you surrender instead of exchange.
Chasing a bonus. A flashy upfront bonus often hides higher fees or a longer surrender period.

Do’s and Don’ts

Do:

Do request a direct insurer-to-insurer transfer, because it keeps the gain tax-deferred under Section 1035.
Do get your surrender schedule and value in writing, because the surrender charge can decide the whole question.
Do compare all-in fees, because the fee gap, not the tax, is usually the real prize.
Do check every rider’s value first, because some legacy guarantees beat anything sold today.
Do confirm the new contract’s surrender period, because a fresh lock-up reduces your flexibility.

Don’t:

Don’t cash out and rebuy, because that single misstep makes your full gain taxable now.
Don’t assume your state ignores annuities, because a few states levy a premium tax that adds cost.
Don’t 1035 an IRA annuity, because qualified contracts use direct transfers instead.
Don’t trust a verbal quote, because surrender values and rider numbers change daily.
Don’t move under 59½ without checking the penalty, because a botched exchange can cost an extra 10%.

Pros and Cons of a 1035 Exchange

Pros:

No tax on the swap, because Section 1035 defers your embedded gain entirely.
Lower ongoing fees, because a modern low-cost annuity can run under 0.65% all-in.
Preserved cost basis, because your original basis carries to the new contract.
Protected losses, because an underwater contract keeps its high basis after the exchange.
Better investment options, because newer contracts often offer cheaper, broader fund menus.

Cons:

Possible surrender charge, because the old insurer’s penalty still applies during the surrender period.
A new surrender clock, because the replacement contract may lock you up again.
Lost living benefits, because valuable GMWB or GMIB guarantees usually disappear.
State premium tax in a few states, because the exchange can trigger a small charge where it applies.
Complexity and paperwork, because a coding error can turn the swap into a taxable event.

The 10% Early-Withdrawal Penalty

If you are under age 59½, surrendering an annuity for cash can trigger a 10% federal penalty on the gain, on top of ordinary income tax. SmartAsset confirms the IRS adds a 10% penalty on earnings taken before 59½. A properly executed 1035 exchange avoids this penalty entirely, because no distribution occurs.

The consequence of missing this is painful for younger owners. Kevin, age 52, surrendered a contract with a $60,000 gain and owed a $6,000 penalty plus income tax. What he should have done: use a 1035 exchange to move the money instead of cashing out. The lesson is that the exchange route protects both the tax deferral and the penalty exposure for anyone under 59½.

State Tax: Federal Free, But Watch Premium Tax

A 1035 exchange is tax-free at the federal level, and most states follow the federal treatment on income tax. So in the large majority of states, the swap is income-tax-free at both levels. State income tax conformity is the norm here, not the exception.

The twist is the premium tax. As annuity.org reports, at least eight states and Puerto Rico levy a premium tax on annuities, generally between 1% and 3.5%. These states include California, Florida, Maine, Nevada, South Dakota, West Virginia, Wyoming, and Puerto Rico, with Nevada the highest near 3.5%. The consequence is a small one-time cost in those states when premium is applied to the new contract. What you should do: if you live in a premium-tax state, ask the new insurer whether and when the premium tax applies, since some states tax at purchase and others at payout.

What to Do Next

Follow these steps in order to make a safe, smart decision.

Pull your contract details. Ask your current insurer in writing for your surrender value, surrender schedule, all-in fee, cost basis, and any rider value.
Decide if a rider is worth keeping. Compare your guaranteed income base to the fee savings before anything else.
Check your surrender period. If a charge applies, calculate whether the fee savings outweigh it or whether waiting is smarter.
Shop low-cost annuities. Compare all-in fees and confirm the new contract’s surrender period.
Request a direct 1035 exchange. Have the new insurer initiate it as a “1035 exchange” so you never touch the funds.
Confirm the 1099-R coding. Expect a Form 1099-R showing a tax-free exchange (often code 6); verify it before you file.
Call a professional for complex cases. If you hold a rich rider, are under 59½, or live in a premium-tax state, a CPA or fee-only advisor is worth the cost.

This article is educational and is not a substitute for advice from a licensed tax or financial professional for your specific situation. A 1035 exchange involving a living benefit rider, a partial exchange, or an underwater contract is complex enough that paying a CPA or fee-only advisor for a one-time review — often a few hundred dollars — can save you far more.

FAQs

Is a 1035 exchange taxable?

No. A properly executed annuity-to-annuity 1035 exchange is tax-free in tax year 2025 and 2026. The gain carries into the new contract and is taxed only when you eventually withdraw the money.

Can I 1035 a variable annuity into a fixed annuity?

Yes. Annuities are like-kind, so a variable annuity can move tax-free into a fixed, fixed-indexed, or another variable annuity. Both contracts must be annuities and have the same owner.

Does a 1035 exchange avoid surrender charges?

No. A 1035 exchange only avoids income tax. The insurer’s surrender charge is a separate contractual cost that still applies if you are inside the surrender period, often up to 7%.

Can I 1035 an annuity held inside my IRA?

No. Section 1035 applies only to non-qualified annuities. For an IRA annuity, use a direct custodian-to-custodian transfer instead, which is also tax-free when done correctly.

Will I owe the 10% early-withdrawal penalty in a 1035 exchange?

No. A proper 1035 exchange is not a distribution, so the 10% penalty for owners under 59½ does not apply. Surrendering for cash instead can trigger it on the gain.

What happens to my cost basis after a 1035 exchange?

It carries over. Your original basis transfers to the new annuity unchanged. If your basis is $120,000, the new contract keeps that $120,000 basis for future tax purposes.

Can I do a partial 1035 exchange?

Yes. The IRS confirmed in Revenue Ruling 2003-76 that a partial annuity exchange is tax-free. Your basis splits proportionally between the old and new contracts based on the amount moved.

How long does a 1035 exchange take?

Usually two to six weeks. The timeline depends on how fast the old insurer releases funds. A direct insurer-to-insurer transfer is the only safe way to keep it tax-free.

Do I get a 1099-R for a 1035 exchange?

Yes. You typically receive a Form 1099-R coded to show a tax-free exchange, often distribution code 6. Verify the coding so the IRS does not treat it as taxable.

Does my state tax a 1035 exchange?

Usually no income tax. Most states follow the federal tax-free rule. But about eight states and Puerto Rico levy a premium tax on annuities, generally 1% to 3.5%, which may add a small one-time cost.

Should I 1035 if I have a guaranteed income rider?

Often no. A rich GMWB or GMIB guarantee can be worth more than the fee savings. Compare your guaranteed income base to the fees before moving, and keep the rider if it is the larger number.

Can I exchange a variable annuity for life insurance?

No. That direction is prohibited under Section 1035 and is fully taxable. You may exchange life insurance into an annuity, but never an annuity into life insurance.

Related reading