Should You 1035 Exchange an Underwater Annuity? (w/Examples) + FAQs

This article reflects federal rules and general state rules as of June 2026 and covers tax year 2025 and the 2026 planning year. Tax law changes — confirm current figures before you act.

Quick Answer

It depends. For tax year 2025, a Section 1035 exchange of an underwater annuity is usually smart only when you plan to keep the money in an annuity, because it carries your high cost basis forward tax-free. If you want out of annuities entirely, surrendering may serve you better — but a deductible loss is rarely available.

An “underwater” annuity is one whose current cash value sits below your cost basis — the after-tax money you put in. That gap is a built-in loss, and the choice you make now decides whether that loss helps you later, gets locked away, or vanishes. The wrong move can cost you a deductible loss, trigger a surrender charge, or saddle a new contract with the same problems.

The stakes are real and time-sensitive. The LIMRA 2025 sales report shows U.S. annuity sales topped $432 billion in 2024, so millions of contracts are in force — and after the bond and market swings of recent years, plenty are underwater right now. If your surrender-charge period is ending or your insurer’s strength is slipping, the clock matters.

💰 How basis “carryover” under Section 1035 protects your future gains from tax.
📉 Whether you can deduct the loss on an underwater annuity (and why most people can’t through 2025).
⚖️ A side-by-side of exchanging versus surrendering, with the real dollar math.
🏛️ How qualified (IRA/403(b)) annuities differ from non-qualified ones in this decision.
🚫 Seven costly mistakes that turn a smart move into a tax trap.

What “Underwater” Means and Why Section 1035 Exists

An annuity is “underwater” when its cash surrender value is less than your investment in the contract. Your investment — the IRS calls it your cost basis or investment in the contract — is the total of after-tax premiums you paid, minus any amounts you already pulled out tax-free. When the market drops, fees pile up, or a variable annuity’s subaccounts fall, the cash value can sink below what you paid. That difference is an unrealized, or “paper,” loss.

Section 1035 of the Internal Revenue Code lets you swap one annuity for another annuity (or for a qualified long-term care contract) without recognizing gain or loss at the time of the swap. Congress created this rule so people could move into a contract that better fits their needs without a tax bill simply for switching. The phrase that matters most for an underwater contract is “no gain or loss shall be recognized.” That means the exchange itself never lets you claim the loss — it only postpones the tax math.

The trade-off is that your cost basis follows you into the new contract. If you paid $100,000 and the value is now $80,000, you carry the full $100,000 basis into the new annuity even though only $80,000 moves over. That preserved basis is the hidden value of an underwater 1035 exchange: future growth is shielded from tax until you have recovered that high basis. The consequence of ignoring this is real — surrender instead of exchange, and you may permanently lose the chance to apply that extra $20,000 of basis against future gains.

A common misconception is that a 1035 exchange “resets” or “wastes” your loss. It does neither. The loss is not deducted, but it is not destroyed either — it lives on as extra basis inside the new annuity. What you should do first is request your cost-basis figure in writing from your current insurer, because every decision below turns on that number.

Which Situation Applies to You?

The right answer depends almost entirely on your contract type and your goal. Find your row below, then read the section it points to. One size never fits here, because qualified and non-qualified annuities follow different tax worlds, and “I want to stay in an annuity” leads to a different answer than “I want out.”

Non-qualified annuity, want to stay in an annuity: A 1035 exchange usually wins. Your high basis carries forward and shelters future gains. Read The Case for Exchanging.
Non-qualified annuity, want out of annuities entirely: Look at surrendering, but know the loss is hard to deduct through 2025. Read The Case for Surrendering and Can You Deduct the Loss?.
Qualified annuity (IRA, 403(b), 401(a)): Cost basis and loss deductions generally do not apply because the money is pre-tax. Read Qualified Annuities Are Different.
Inherited (non-qualified) annuity: A beneficiary can sometimes do a 1035 exchange into their own name. Read the FAQs and see a professional.
Worried about your insurer’s financial health: Exchanging to a stronger carrier can protect your money, underwater or not. Read The Case for Exchanging.

The Case for Exchanging (Keeping Your High Basis)

Exchanging shines when you intend to keep your money in an annuity. The biggest reason is basis preservation. Under the withdrawal rules in IRS Publication 575, non-qualified annuity withdrawals come out earnings-first (taxable) until all gain is gone, then basis-last (tax-free). Carrying a high basis into a new contract means more of your future money can come back tax-free, and any growth up to your old basis is sheltered.

A second reason is escaping a bad contract without a tax event. If your current annuity has high fees, weak investment options, a poor income rider, or an insurer with a slipping financial-strength rating, a 1035 exchange lets you move to a better contract while the IRS treats it as a non-event. The consequence of not moving from a failing insurer can be severe — if the carrier becomes insolvent, state guaranty associations cover only limited amounts, often around $250,000 in present value, and limits vary by state.

A third reason is locking in the loss as future tax shelter. Say Maria, age 58, paid $150,000 into a variable annuity now worth $120,000. She still wants tax-deferred growth, so she exchanges into a lower-cost contract. She carries her full $150,000 basis forward. If the new contract grows back to $150,000, she can surrender it with zero taxable gain, because she never recovered her basis. The misconception to avoid is that exchanging “gives up” the loss; in Maria’s case, the carried basis is exactly what saves her tax later. What she should do is confirm the new insurer codes the incoming basis correctly — get it in writing.

The Case for Surrendering (Cashing Out)

Surrendering means cancelling the contract and taking the cash. For an underwater non-qualified annuity, a full surrender produces no taxable income, because you receive less than your basis. Per Publication 575’s surrender rule, a full surrender is tax-free to the extent of cost you have not yet recovered. So cashing out an underwater contract is not a tax problem — the question is whether you can also deduct the loss.

Surrendering makes sense when you no longer want any annuity, the surrender-charge period has ended, and you would rather invest the cash elsewhere (a brokerage account, a CD, or paying down debt). It also makes sense when the dollar gap is small and the freedom is worth more than preserving basis you may never use. The consequence to watch for is a surrender charge: if you are still inside the surrender-charge window, the insurer keeps a percentage, and on an already-underwater contract that deepens your loss.

Picture James, age 67, who paid $80,000 into a fixed indexed annuity now worth $72,000 with no surrender charge left. He wants the money in a high-yield savings account, not another annuity. He surrenders, receives $72,000, and owes no income tax because he got back less than his basis. The misconception many share is that a loss this size produces a juicy tax deduction. As the next section shows, that is rarely true today. What James should do is request the surrender in writing and confirm no market value adjustment (MVA) applies before signing.

Can You Deduct the Annuity Loss? (The Hard Truth Through 2025)

This is where most readers are misled. In theory, a loss on a non-qualified annuity surrendered for less than its basis can be an ordinary loss on a transaction entered into for profit, supported by IRS guidance such as Revenue Ruling 61-201 and longstanding practice. But how you claim it is the catch, and the catch is brutal for tax years 2018 through 2025.

Many advisors treat the annuity loss as a miscellaneous itemized deduction subject to the 2%-of-AGI floor. The Tax Cuts and Jobs Act suspended all 2%-floor miscellaneous itemized deductions from 2018 through 2025. That means for tax year 2025, most people who surrender an underwater annuity get no federal deduction for the loss at all. The consequence is stark: surrender in 2025 expecting a write-off, and you may simply lose the loss with nothing to show for it.

A minority position argues the loss belongs “above the line” as an ordinary loss not subject to the 2% floor, which would survive the suspension — but the IRS has never blessed this clearly, and it is contested. Because this is unsettled, treat any annuity-loss deduction as uncertain and get a CPA or tax attorney to opine on your specific facts before relying on it. The misconception to bury is “I’ll just write off the loss” — for 2025, assume you cannot, and let the deduction be a bonus, not a plan. What you should do is compare the certain benefit of carried-forward basis (exchange) against the uncertain benefit of a loss deduction (surrender).

Federal vs. State: Two Layers You Must Separate

Federal law sets the baseline, but your state may or may not follow it. Never assume conformity, because the answer genuinely varies.

Federal treatment (tax year 2025)	What it means for you
1035 exchange recognizes no gain or loss; basis carries forward	Switching annuities is tax-free federally if done as a direct transfer
Full surrender of an underwater annuity is tax-free up to unrecovered basis	You owe no federal income tax on cash you get back below basis
Annuity loss deduction as a 2%-floor miscellaneous item is suspended through 2025	Most surrenderers get no federal write-off for the loss in 2025

State rules add a second layer that can change the picture. Many states with income taxes conform to the federal 1035 treatment, so the exchange is also state-tax-free — but you must verify with your state’s department of revenue. No-income-tax states such as Florida, Texas, Tennessee, and Washington simply do not tax annuity income, so the state question is moot there, and that clean answer is genuinely complete.

Some states decoupled from the TCJA suspension of miscellaneous deductions, meaning a loss you cannot deduct federally might still help on your state return. The consequence of ignoring state law is overpaying — or wrongly claiming a deduction your state does not allow. What you should do is check your state department of revenue’s conformity guidance, or have your preparer confirm it, before you file.

Qualified Annuities Are Different

If your annuity sits inside an IRA, 403(b), 401(a), or 403(a) plan, the entire “underwater loss” conversation changes. As Publication 575 explains, money in these accounts is generally pre-tax, so you usually have no cost basis to speak of. With no basis, there is no investment loss to deduct, because you were never taxed on the money going in.

For a qualified annuity, moving between contracts is usually handled as a trustee-to-trustee transfer within the plan, not a classic 1035 exchange — though Section 1035 can apply to like-kind annuity swaps inside the same plan. The CPA guidance from Ketel Thorstenson stresses the make-or-break rule: the transfer must go directly between insurers, with no check to you. The consequence of receiving the money yourself, even for a moment, is that the IRS can treat the whole amount as a taxable distribution, plus a 10% early-distribution penalty if you are under 59½.

Consider Linda, age 61, with a 403(b) annuity that lost value. She has no basis, so there is no loss to harvest. Her smart move is a direct transfer to a lower-cost 403(b) annuity to cut fees, reported with code 6 on Form 1099-R for a tax-free 1035 exchange. The misconception to drop is “I can deduct my IRA annuity’s loss” — you generally cannot. What Linda should do is insist on a direct, insurer-to-insurer transfer and keep the paperwork.

A Fully Worked Numeric Example

Numbers make the choice concrete. Meet Robert, age 62, who holds a non-qualified variable annuity. He paid $200,000 in after-tax premiums (his basis). The contract is now worth $160,000 — underwater by $40,000. His surrender-charge period has ended, so no charge applies. His marginal federal tax rate is 24%, and his AGI is $150,000.

Option A — Exchange into a lower-cost annuity (he wants to stay invested): – He moves $160,000 via 1035 exchange and carries forward the full $200,000 basis. – The new contract has lower annual fees, saving roughly 1% a year, about $1,600 in year one. – If the contract grows back to $200,000, he can surrender with $0 taxable gain, because he has not recovered his $200,000 basis. – Tax today: $0. Future tax sheltered on up to $40,000 of recovery: about $9,600 (at 24%).

Option B — Surrender and invest elsewhere: – He receives $160,000 tax-free (below basis, so no income tax). – He hopes to deduct the $40,000 loss — but for tax year 2025, as a 2%-floor miscellaneous itemized deduction, the TCJA suspension means his deduction is $0. – Net tax benefit of the loss in 2025: $0 (unless the contested above-the-line position holds, which is uncertain).

For Robert, who still wants tax-deferred growth, Option A is clearly stronger: he keeps a real, bankable basis advantage worth roughly $9,600 in future tax savings plus lower fees, versus a loss deduction that the law currently zeroes out. Had Robert wanted out of annuities entirely, Option B’s tax-free return of $160,000 would still be clean — he just would not get the write-off he expected.

Three Common Scenarios

Scenario 1 — Stay invested, exchange to cut fees

Your move	The result
1035 exchange a $120,000 (basis $150,000) variable annuity into a low-cost contract	No tax today; $150,000 basis carries forward; future growth to $150,000 is tax-free
Confirm direct insurer-to-insurer transfer	Avoids any chance of a taxable distribution

Scenario 2 — Want out, surrender after charges end

Your move	The result
Fully surrender an underwater non-qualified annuity for $72,000 (basis $80,000)	Receive $72,000 with no income tax (below basis)
Expect a deductible loss in 2025	Likely $0 federal deduction due to TCJA suspension through 2025

Scenario 3 — Weak insurer, protect the money

Your move	The result
1035 exchange from a low-rated carrier to an A-rated insurer	Money moves tax-free; basis preserved; stronger guaranty backing
Surrender to a check instead	Same tax-free cash, but you lose basis carryforward and annuity protections

Surrender Charges, MVAs, and Timing

The tax answer is only half the decision; contract mechanics often matter more. A surrender charge is a penalty the insurer keeps if you exit early, often starting around 7%–10% and declining to zero over 5–10 years. On an already-underwater contract, a surrender charge deepens your loss and can wipe out any fee savings from exchanging. The consequence of moving too early is paying to escape a problem you could have waited out — check your charge schedule first.

A market value adjustment (MVA) applies to some fixed and indexed annuities. It raises or lowers your cash value based on interest-rate moves since you bought the contract. When rates have risen since purchase, an MVA can push your payout down, making an underwater contract worse if you exit now. Bonus annuities add another trap: some recapture a “premium bonus” if you leave during the surrender period, so the value you see may not be the value you get.

Timing also affects strategy. If your surrender-charge period ends in a few months, waiting can save thousands. James from earlier waited until his charge hit zero before deciding — the right call. What you should do is request a current in-force illustration and the exact surrender value, including any MVA and bonus recapture, in writing before you choose exchange or surrender.

Seven Mistakes to Avoid

Taking a check instead of a direct transfer. A constructive receipt converts a tax-free 1035 exchange into a taxable distribution, with a possible 10% penalty if you are under 59½.
Assuming you’ll deduct the loss in 2025. The TCJA suspended 2%-floor miscellaneous deductions through 2025, so most surrenderers get no write-off — planning around a phantom deduction backfires.
Surrendering during the surrender-charge period. You pay a penalty that deepens your loss and may erase any benefit of moving.
Ignoring a market value adjustment. An MVA can cut your payout when rates have risen, making an exit costlier than the screen value suggests.
Not confirming basis carryover with the new insurer. If the receiving carrier records the wrong basis, you can lose tax-free recovery you were entitled to.
Exchanging into a contract that’s just as bad. Moving from one high-fee annuity to another wastes the chance and may restart a new surrender-charge clock.
Treating a qualified annuity like a non-qualified one. There is generally no basis or deductible loss inside an IRA or 403(b), and a botched move can trigger tax and penalties.

Do’s and Don’ts

Do get your cost basis in writing first, because every decision depends on that number.
Do use a direct insurer-to-insurer 1035 transfer, so the IRS treats it as a non-event.
Do compare total fees of the old and new contracts, since fee savings often justify the move.
Do check your insurer’s financial-strength rating, because protecting principal can matter more than tax.
Do confirm your state’s conformity, since state tax can differ sharply from federal.
Don’t cash out expecting a 2025 loss deduction, because the law likely zeroes it out.
Don’t exit during a surrender-charge window without doing the math, or you deepen your loss.
Don’t let proceeds touch your bank account in a qualified transfer, or you risk a taxable distribution.
Don’t assume an inherited annuity follows the same rules, because beneficiary 1035 options are narrow.
Don’t rely on a salesperson’s verbal promise about basis, because only the contract paperwork controls.

Pros and Cons of Exchanging an Underwater Annuity

Pro: Your high basis carries forward, sheltering future gains from tax — a concrete, bankable benefit.
Pro: You can escape high fees or a weak insurer without a tax bill, improving your long-term outcome.
Pro: No income tax is due on the swap, so all your money stays working for you.
Pro: You preserve annuity features like death benefits and lifetime income that a brokerage account lacks.
Pro: It buys time for an underwater contract to recover within a better, cheaper vehicle.
Con: You give up any chance to claim a loss deduction, because 1035 recognizes no loss.
Con: A new contract may start a fresh surrender-charge period, locking you in again.
Con: You stay in the annuity “wrapper,” which is wrong if you no longer want an annuity.
Con: Mishandling the transfer can trigger unexpected tax, so paperwork must be exact.
Con: If you never recover the basis, the preserved basis benefit may go partly unused.

What to Do Next

Get the numbers in writing. Ask your insurer for your cost basis, current cash surrender value, surrender-charge schedule, and any MVA or bonus recapture.
Decide your real goal. Do you want to stay in an annuity (lean exchange) or get out entirely (consider surrender)?
Run the comparison. Weigh the certain basis-carryforward benefit against the uncertain, likely-zero 2025 loss deduction.
Check qualified vs. non-qualified. If it’s an IRA or 403(b), plan a direct trustee-to-trustee transfer and skip the loss analysis.
Confirm state conformity. Verify your state’s treatment with your state department of revenue or your preparer.
Use a direct transfer. Never take a check; have the new insurer pull the funds directly, and confirm basis carryover in writing.
Call a professional when it’s complex. A CPA or tax attorney should weigh in if the contract is large, you’re considering the contested loss-deduction position, or an inherited annuity is involved — expect a few hundred dollars for a focused consult.

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

FAQs

Can I deduct the loss on an underwater annuity? Usually not for tax year 2025. A loss on a surrendered non-qualified annuity is typically a 2%-floor miscellaneous itemized deduction, which the TCJA suspended through 2025. A contested above-the-line position exists but is uncertain.

Does a 1035 exchange let me claim my annuity loss? No. Section 1035 recognizes “no gain or loss,” so the exchange never produces a deductible loss. Your loss instead survives as extra cost basis inside the new annuity.

Is surrendering an underwater annuity taxable? No. A full surrender for less than your cost basis produces no taxable income, because you are getting back part of your own after-tax money, per IRS Publication 575.

What happens to my cost basis in a 1035 exchange? It carries forward in full. Even though only the lower cash value moves, your entire original basis transfers to the new contract, sheltering future gains until you recover it.

Can I 1035 exchange an IRA or 403(b) annuity? Sometimes, via direct transfer. Qualified annuity moves are usually trustee-to-trustee transfers within the plan; a like-kind 1035 can apply, but there’s generally no basis or deductible loss involved.

Will I owe a penalty if I move my annuity? Not on a proper exchange. A direct 1035 exchange is not a distribution. But if you take a check yourself on a qualified annuity, you risk income tax plus a 10% penalty before age 59½.

Does my state tax a 1035 exchange? Most conforming states do not. Many states follow federal 1035 treatment, and no-income-tax states like Florida and Texas don’t tax it at all — but confirm with your state department of revenue.

What is a market value adjustment, and why does it matter? A rate-based change to your payout. An MVA can lower your surrender value when interest rates have risen since purchase, which can make an underwater contract worse if you exit now.

Should I exchange if my insurer’s rating is dropping? Often yes. A 1035 exchange to a stronger, higher-rated carrier protects your principal tax-free, since state guaranty associations cover only limited amounts if an insurer fails.

Can a beneficiary 1035 exchange an inherited annuity? Sometimes. A surviving spouse or beneficiary may move a death benefit into their own annuity via 1035 to defer tax, reported with code 6 on Form 1099-R. Rules are narrow — see a professional.

How long does a 1035 exchange take? Usually two to six weeks. The receiving insurer initiates the transfer with the old carrier; timing depends on both companies and whether any in-force illustration or paperwork is delayed.

What form reports a 1035 exchange? Form 1099-R, code 6. The old insurer issues a Form 1099-R with distribution code 6 to show a tax-free Section 1035 exchange; you generally report it but owe no tax on the swap.

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