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Tax Strategy

Exchanging One Annuity for Another: The 1035 Exchange

Section 1035 of the U.S. Tax Code allows you to move from one annuity to another without paying taxes on accumulated gains — but only if the exchange is done correctly and for the right reasons.

8 min read

Overview

Should You Exchange Your Annuity?

If you are considering exchanging one annuity for another, you are likely looking for better rates, improved features, or a product that more closely fits your current retirement goals. The good news is that the IRS provides a legal mechanism to make this switch without triggering a taxable event — provided you follow the rules precisely.

A 1035 exchange enables you to move from one annuity to another without paying taxes on the accumulated gains inside the contract. As is usual when dealing with the IRS, things can get complicated quickly if not done correctly and can end up costing you time, aggravation, and fees. Do your research and consult your financial advisor before proceeding. If you are executing a particularly complicated exchange — such as one variable annuity for another or a partial 1035 exchange — you should also consult a tax professional.

You should only consider a 1035 exchange when you know that you are getting a definite benefit from the new product. Think of it like trading in your old car for a new one. Your old car still runs fine, but the new one may have better features, longer warranty, and improved performance. The same logic applies: if your current annuity is performing well, meeting your needs, and still in its surrender period, the case for exchange is weak. If a better product meaningfully improves your situation, the exchange may make perfect sense.

The industry is self-regulating to a meaningful extent. Once you and your trusted financial advisor have discussed the exchange, you will complete a “suitability form” that documents the reasons for the exchange — listing all of the benefits and any drawbacks that are deemed negligible in light of the gains. A broker at the receiving insurance company (not the advisor selling you the new annuity) reviews this form. If the exchange is deemed to offer little or no benefit, it may be disallowed.

Key Definition

What Is a 1035 Exchange?

A 1035 Exchange is a provision under Section 1035 of the U.S. Tax Code that allows the owner of a life insurance policy or annuity contract to transfer the value to a new policy or contract of the same type — without recognizing the gain as taxable income at the time of the transfer.

The key requirement: the funds must move directly between insurance companies. If you receive the proceeds first and then purchase a new annuity, the transaction is taxable. The 1035 exchange must be a direct, institution-to-institution transfer.

Any kind of deferred annuity can be exchanged for any other kind of annuity. However, an annuity that has already been converted to an income stream (“annuitized”) cannot be exchanged.

Step-by-Step

How a 1035 Exchange Works

From your first conversation with an advisor to the completed transfer — here is what the process looks like in practice.

Evaluate Your Current Annuity

Review your existing contract’s surrender period, current rate, death benefit provisions, and whether your policy has accumulated gains. If you are still within a surrender charge period, those fees will reduce or eliminate any benefit from the exchange. If your annuity is performing well and meeting your needs, exchange is likely not warranted.

Compare the New Product in Detail

Work with your advisor to compare the features of your existing annuity side-by-side with the annuity you are considering. Key comparison points include: interest rate or crediting method, new surrender period, death benefit terms, rider options, and total fee load. Ask your advisor directly: “What commission will you receive on this exchange?” A trustworthy advisor will answer clearly.

Complete the Suitability Form

Once you and your advisor agree the exchange is in your best interest, you will complete a suitability form documenting the reasons for the exchange. This form is reviewed by a compliance officer at the new insurance company. If the exchange cannot be justified as beneficial to you, it can be denied — a meaningful consumer protection built into the process.

Initiate the Direct Transfer

The transfer must move directly between the two insurance companies — you cannot receive the funds personally without triggering a taxable event. Your new carrier will handle the paperwork requesting the funds from your existing carrier. Do not take a distribution check; the moment the funds pass through your hands, the tax deferral is lost.

Plan for the Timeline

Do not expect a 1035 exchange to happen overnight. Two different insurance companies are involved and there is significant paperwork on both sides. Plan for several weeks — sometimes longer — for the transfer to complete. Ensure all documentation is completed professionally and that you have confirmed receipt before assuming the exchange is final.

IRS Rules

What Can Be Exchanged for What?

The IRS permits specific exchanges under Section 1035. The table below shows which transfers qualify for tax-free treatment — and which do not.

Exchange From	Exchange To	1035 Qualifies?	Notes
Life Insurance Policy	Annuity Contract	✓ Permitted	One-way only — you cannot exchange an annuity for a life insurance policy.
Life Insurance Policy	Life Insurance Policy	✓ Permitted	Must be same insured. Commonly used to upgrade policy terms or carrier.
Deferred Annuity	Deferred Annuity	✓ Permitted	Any deferred annuity (fixed, indexed, or variable) can be exchanged for any other deferred annuity.
Fixed Annuity	Indexed Annuity	✓ Permitted	Common scenario — moving from a lower-yielding fixed to a higher-potential indexed product.
Variable Annuity	Fixed or Indexed Annuity	✓ Permitted	Also permitted in reverse. Variable-to-variable is the most complex and may require tax professional review.
Annuitized (Income) Annuity	Any Annuity	✗ Not Permitted	Once annuitized, the contract cannot be exchanged. Income stream has begun; the exchange window is closed.
Annuity Contract	Life Insurance Policy	✗ Not Permitted	The IRS does not allow exchange of an annuity into a life insurance policy under Section 1035.

This table summarizes general IRS rules as of 2024. Tax laws can change. Always confirm the current rules with a qualified tax advisor before executing any exchange.

Why Exchange

Benefits of a 1035 Exchange

When executed for the right reasons, a 1035 exchange can meaningfully improve your retirement income position without triggering an immediate tax bill.

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Access to Better Rates

Annuity interest rates fluctuate over time. If you purchased a fixed annuity when rates were low — say 3% — and the market now offers 5% or more, a 1035 exchange can move your accumulated value into a higher-yielding product without the tax hit that a straight withdrawal and repurchase would generate.

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Tax Deferral Preserved

The most significant benefit of a 1035 exchange is that your accumulated gains — which would be fully taxable at ordinary income rates if you surrendered and repurchased — continue to grow tax-deferred inside the new contract. No taxes are owed at the time of the exchange, only when distributions are eventually taken.

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Improved Contract Features

Annuity products have evolved significantly. Newer contracts may offer better rider options, improved death benefit provisions, lower fees, or more flexible income start dates than a product purchased 5–10 years ago. A 1035 exchange allows you to upgrade to a more competitive contract without sacrificing the tax-deferred status of your accumulated value.

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Tax Planning Through Partial Exchanges

A partial 1035 exchange can be a powerful tax planning tool. By splitting a large annuity into two contracts and drawing distributions from one while deferring the other, you can spread taxable income across multiple years — potentially keeping yourself in a lower bracket. The IRS now requires only a 180-day waiting period before taking disbursements from an exchanged portion, down from the prior one-year rule.

Common Mistakes

Pitfalls to Avoid

A poorly executed 1035 exchange can cost you more than it saves. These are the mistakes that most frequently derail an otherwise sound strategy.

Exchanging During a Surrender Period

If you exchange out of an annuity before its surrender charge period has expired, you will owe surrender fees to the existing carrier. These fees can be substantial — often 7–10% of contract value in the early years. The gains from a new contract must exceed the surrender cost by a meaningful margin to justify the exchange. Always confirm where you are in your current surrender schedule before proceeding.

Accepting Cash Before the Transfer Completes

The single most common and costly error in a 1035 exchange is receiving a distribution check rather than arranging a direct carrier-to-carrier transfer. The moment the funds pass through your hands, the deferred gains become taxable. If you are also under age 59½, the IRS will assess an additional 10% early withdrawal penalty on top of ordinary income tax. Always confirm that the transfer is institution-to-institution.

Exchanging Without a Clear, Verifiable Benefit

The exchange should only happen when there is a definite, documentable advantage in the new product. Exchanging simply because a salesperson recommends it — or because a new contract “sounds better” — is not sufficient justification. Ask your advisor to demonstrate the specific benefit in writing, side-by-side. If they cannot quantify why the new product is superior, the exchange is not justified and may not pass the carrier’s suitability review.

Ignoring the New Surrender Period

A 1035 exchange into a new annuity resets your surrender period. Your new contract will most likely come with a new surrender charge schedule — often 5 to 10 years. The gains you make on the exchange could be completely wiped out if you are forced to access the money before the new surrender period expires. This risk is compounded if you are under age 59½ and subject to the 10% early withdrawal penalty from the IRS as well.

Questions & Answers

1035 Exchange: Common Questions

1 What does “1035 exchange” mean? ▼

A 1035 exchange refers to Section 1035 of the U.S. Internal Revenue Code, which allows the tax-free transfer of value from one life insurance policy or annuity contract to another of the same type. The name comes directly from the section number in the tax code. When someone says they are “doing a 1035,” they mean they are moving their annuity’s accumulated value directly to a new annuity without triggering a taxable event on the deferred gains inside the contract.

2 Can I exchange a variable annuity for a fixed annuity using a 1035 exchange? ▼

Yes. The IRS permits the exchange of any deferred annuity for any other type of deferred annuity under Section 1035. This includes variable-to-fixed, fixed-to-indexed, variable-to-indexed, and the reverse of each. The one exception is an annuitized contract: once you have converted your annuity into an income stream, the ability to execute a 1035 exchange is lost. As long as the contract remains in its accumulation (deferral) phase, the exchange is permitted. Variable-to-variable exchanges are technically allowed but are the most complicated and should always involve a tax professional given the potential for complex basis calculations.

3 Will I owe taxes on a 1035 exchange? ▼

Not at the time of the exchange, provided it is executed correctly. The deferred gains inside your existing annuity — which would normally be taxed as ordinary income if you surrendered the contract — are carried over to the new contract and continue to grow tax-deferred. Taxes become due only when you eventually take distributions from the new annuity. The critical requirement is that the funds must transfer directly between insurance companies. If you receive the proceeds personally before purchasing a new annuity, the gains are immediately taxable and the 1035 exchange status is forfeited.

4 What is a partial 1035 exchange, and when does it make sense? ▼

A partial 1035 exchange transfers only a portion of your existing annuity’s value into a new contract. For example, if you have a deferred annuity worth $200,000 — with $100,000 in original premium and $100,000 in accumulated gains — you might exchange $100,000 into a new contract and retain the other $100,000 in the original. This can be used as a tax management strategy: you could begin taking distributions from one contract while continuing to defer the other, spreading your taxable income across multiple years. Partial exchanges are complicated and the IRS imposes specific rules on how the taxable basis is allocated between the two contracts. Consult a tax professional before executing a partial exchange. Note: as of October 2011, the waiting period before taking disbursements from the newly exchanged portion was reduced from one year to 180 days.

5 How long does a 1035 exchange take? ▼

A 1035 exchange typically takes several weeks to complete — sometimes longer. Two separate insurance companies are involved, and both must process substantial paperwork. The existing carrier must process a surrender or transfer request, and the new carrier must receive and confirm the incoming funds. Do not plan around a specific date for the exchange to be final. Complete all documentation carefully and professionally, confirm receipt of funds with the new carrier before assuming the process is done, and keep copies of all exchange paperwork for your tax records.

6 Can an advisor be required to disclose their commission on a 1035 exchange? ▼

Yes — and you should always ask. When a 1035 exchange is being recommended, you have every right to know exactly what commission the advisor will receive on the new contract, and whether that commission varies depending on how the new annuity is structured or which riders are added. A straightforward advisor will answer this question directly. The presence of a commission is not inherently a problem — advisors are legitimately compensated for their work — but the commission structure should never be the driving reason behind an exchange recommendation. The suitability review process at the new carrier provides one layer of protection, but asking the question yourself is the most direct safeguard.

Questions About Exchanging Your Annuity?

A licensed advisor can run a side-by-side comparison of your current contract and any new product — so you can see exactly what you stand to gain before you commit to an exchange.

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