1035 Exchange Annuity: Tax-Free Transfer Rules

A 1035 exchange lets you move the value of one annuity contract into another annuity contract without reporting the gain as income in the year of the transfer. Section 1035 of the Internal Revenue Code permits it, cost basis carries over to the new contract, and the money must move directly between insurance companies.

That is the tax half of the story. The other half is what the exchange costs you: a new surrender charge schedule on the new contract, and a new commission paid to the agent who writes it. Both are real, both are ordinary, and both belong in the conversation before anyone signs an application. This page covers the tax rules from the IRS, the sales-practice rules from FINRA and the NAIC, and the two Florida statutes that govern how a replacement recommendation has to be made and how long you have to change your mind.

What is a 1035 exchange?

A 1035 exchange is a tax-free exchange of one insurance or annuity contract for another under Section 1035 of the Internal Revenue Code. Instead of surrendering the old contract, recognizing the gain, and buying a new policy with what is left, the policyholder exchanges the existing contract directly for the new one. No income tax is due on the gain at the time of the exchange, and the tax deferral that built up inside the original contract continues inside the new one.

The SEC’s investor education site defines Section 1035 as the part of the tax code that “allows you to exchange an existing variable annuity contract for a new annuity contract without paying tax on the income and investment gains in your current account,” and notes in the same entry that surrender charges on the old contract can still apply (Investor.gov, Section 1035).

Two things a 1035 exchange is not. It is not a way to get money out of an annuity without tax — it defers the tax on the gain, it does not erase it. And it is not the same thing as a rollover. Rollovers move qualified retirement money between IRAs and employer plans. Section 1035 governs the exchange of insurance and annuity contracts, and it is most commonly used with non-qualified annuities funded with after-tax dollars.

Which exchanges Section 1035 permits

The IRS spells out the qualifying combinations in the Instructions for Forms 1099-R and 5498. A tax-free section 1035 exchange is the exchange of:

A life insurance contract for another life insurance contract, for an endowment or annuity contract, or for a qualified long-term care insurance contract
A contract of endowment insurance for another endowment contract that begins regular payments no later than the old contract would have, for an annuity contract, or for a qualified long-term care insurance contract
An annuity contract for an annuity contract, or for a qualified long-term care insurance contract
A qualified long-term care insurance contract for another qualified long-term care insurance contract

Those four categories are the whole list (IRS, Instructions for Forms 1099-R and 5498).

The one-way rule

Read the list again and the asymmetry shows up. A life insurance policy can be exchanged for an annuity. An annuity cannot be exchanged for a life insurance policy. The IRS list allows an annuity contract to go only to another annuity contract or to a qualified long-term care insurance contract — life insurance is not among the permitted destinations.

FINRA states the same rule in plainer language in its investor guidance on exchanging a life insurance policy: you can exchange a life insurance policy for another life insurance policy or for an annuity, but you cannot exchange an annuity for life insurance under these tax-free rules (FINRA, Should You Exchange Your Life Insurance Policy?).

The reason is structural rather than arbitrary. Gain inside an annuity is taxed as ordinary income when it comes out. Life insurance death benefits generally pass income-tax-free. Allowing the exchange to run in that direction would let untaxed annuity gain be converted into a tax-free death benefit, so the code only lets it run the other way.

Exchanging a life insurance policy into an annuity

The other direction is permitted, and it is a common use of the provision. An owner of a permanent life insurance policy — whole life, or a universal life insurance policy — who no longer needs the death benefit but has accumulated cash value can exchange that cash value into an annuity contract without recognizing the gain. The death benefit ends, the tax deferral continues, and the cost basis from the life insurance policy carries into the new annuity. Fixed annuities, fixed indexed annuities and variable annuities can all serve as the receiving contract, subject to what the issuing insurance company will accept. If there is an outstanding policy loan on the life insurance policy, raise it early: loan balances that are extinguished in the exchange can produce taxable income even though the exchange itself is otherwise tax-free.

Exchanges into qualified long-term care insurance

The list above includes a route that many annuity owners do not know exists: an annuity contract may be exchanged for a qualified long-term care insurance contract. So may a life insurance policy or an endowment contract. This is a real planning option for someone holding a non-qualified annuity with substantial gain who is more concerned about long-term care expenses than about leaving the contract intact, because it converts a contract whose gain would be taxable on withdrawal into coverage that can pay for long-term care.

The exchange has to be into a contract that meets the tax definition of a qualified long-term care insurance contract. Not every long-term care insurance policy or hybrid product qualifies, and whether a particular contract does is a question for the issuing insurance company and a qualified tax professional, not something to assume from a brochure.

The money has to move directly between insurers

A 1035 exchange is a transfer between insurance companies, not a surrender followed by a purchase. If the policyholder takes possession of the money first, the transaction fails.

The IRS addressed exactly this in Revenue Ruling 2007-24. A taxpayer received a check from a life insurance company under a non-qualified annuity contract and endorsed it over to a second company to buy a new annuity. The IRS held that “the endorsement of the check to a second company as consideration for a second annuity contract does not qualify as a tax-free exchange under § 1035(a)(3).” Its reasoning was that “there was no actual exchange of annuity contracts; nor did A assign the IC1 contract to IC2; nor was there a direct transfer from IC1 to IC2 of the cash value of the old contract in exchange for the new contract” (IRS, Rev. Rul. 2007-24).

FINRA puts it in one sentence: “The old insurance policy must be exchanged for a new policy—you cannot receive a check and apply the proceeds to the purchase of a new insurance policy.”

How the transfer of funds works

The policyholder applies for the new annuity with the receiving insurance company and signs a 1035 exchange form assigning the existing contract to it.
The receiving company sends the assignment and transfer request to the life insurance company that issued the old annuity.
That company transfers funds directly to the receiving company and reports the cost basis along with the value.
The old annuity terminates and the new annuity is issued, with its own contract date, its own surrender charge schedule and its own death benefit.
The issuing company sends a Form 1099-R showing a taxable amount of zero.

Nothing passes through the owner’s hands at any step. A well-run exchange also leaves the old contract in force until the transfer settles, so there is no window in which the owner holds neither contract.

Cost basis carries over

Section 1035(d)(2) points to Section 1031(d) for basis, with the result that property acquired in a Section 1035 exchange has the same basis as the property exchanged, adjusted as of the date of the exchange. The IRS applied that rule in Revenue Ruling 2003-76, holding in a partial exchange that the taxpayer’s basis in the new contract equaled the proportional share of basis in the old one (IRS, Rev. Rul. 2003-76).

The practical meaning: the gain does not disappear, it travels. If a non-qualified annuity holds $180,000 with $100,000 of premiums paid in, the $80,000 of gain is still $80,000 of gain inside the new contract. Whenever it eventually comes out as a withdrawal, the tax on the gain is ordinary income tax, not capital gains. Anyone who exchanges a heavily appreciated contract should keep the basis records from the original contract permanently. Insurance companies change administrators and lose paperwork; the tax consequences of a lost basis record fall on the contract owner.

How the exchange is reported on Form 1099-R

A 1035 exchange is generally reported even though nothing is taxable. The issuing company reports the transaction on Form 1099-R by entering the total value of the contract in box 1, zero in box 2a as the taxable amount, the total premiums paid in box 5, and distribution code 6 in box 7 — code 6 being the code the IRS assigns to section 1035 exchanges (IRS, Instructions for Forms 1099-R and 5498).

Receiving that form is normal. It is not a sign that something went wrong or that you have to pay taxes. It is the paper trail showing the IRS that a contract moved and that the taxable amount was zero. Box 5 is worth photographing, because it is the carried-over basis figure. Give the form to whoever prepares the return so the transaction is handled correctly.

Partial 1035 exchanges and the 180-day rule

Section 1035 also permits a partial exchange: moving part of an annuity contract’s value into a new annuity contract and leaving the rest where it is. This can be useful when only a portion of a contract needs to change — for instance, splitting a large contract so that one piece can be annuitized later.

The IRS attaches a waiting period. Under Revenue Procedure 2011-38, a partial exchange is treated as a tax-free exchange if no amount, other than an amount received as an annuity for a period of ten years or more or during one or more lives, is received under either the original contract or the new contract during the 180 days beginning on the date of the transfer. If a withdrawal is taken from either contract inside that window, the automatic treatment does not apply and the IRS looks at the substance of the transaction under general tax principles (IRS, Rev. Proc. 2011-38).

So a partial exchange is not a way to pull cash out of an annuity tax-free. Take a withdrawal from either side inside 180 days and the whole arrangement is exposed to being recharacterized. Anyone planning a partial exchange who also expects to need cash within six months should work through the sequencing and the tax consequences with a qualified tax professional first.

The two costs nobody volunteers: a new surrender schedule and a new commission

This is the part of the conversation that gets skipped, so here it is plainly.

A 1035 exchange generally restarts the surrender charge schedule. The new annuity contract comes with its own surrender period, typically running several years from the date the new contract is issued, during which a withdrawal above the free-withdrawal amount is reduced by a surrender charge. The SEC’s investor bulletin on variable annuities states it directly: “If you exchange contracts, you may be required to pay surrender charges on the old annuity if you are still in the surrender charge period. In addition, a new surrender charge period may begin when you exchange into the new annuity” (SEC, Updated Investor Bulletin: Variable Annuities). Someone two years from the end of an existing surrender period who exchanges into a new contract may have traded two remaining years of restriction for seven or ten new ones. Our explainer on how annuity surrender charges work walks through the mechanics.

A 1035 exchange generally pays a new commission to the agent who writes the new contract. Annuities compensate the selling agent when a contract is issued. Exchange into a new contract and a new commission is generated, whether or not the exchange improves the client’s position. The SEC bulletin tells investors to “Consider the financial motivation your financial professional may have to recommend that you exchange one contract for another.” FINRA’s guidance on policy exchanges lists the question an investor should ask outright — “Will you be paid a commission for the exchange, and if so, how much is it?” — and adds: “Only exchange your life insurance policy if you determine, after knowing all of the facts, that the exchange is better for you and not just better for the person trying to sell you the policy.”

That conflict of interest is inherent in how annuities are distributed. It does not make every exchange improper. It does mean an exchange recommendation should be able to survive the question “what does the client get that the current contract does not provide, and is it worth a fresh surrender period?” If the answer is thin, the answer is no.

Why regulators watch annuity exchanges

Repeatedly moving a client from contract to contract to generate commissions is churning, and it is the specific abuse the exchange rules were built to catch.

FINRA Rule 2330 governs recommendations of deferred variable annuities and requires the registered representative, before recommending an exchange, to consider whether the customer “would incur a surrender charge, be subject to the commencement of a new surrender period, lose existing benefits,” and whether “the customer has had another deferred variable annuity exchange within the preceding 36 months” (FINRA Rule 2330). That 36-month lookback exists because a pattern of exchanges is the fingerprint of churning. FINRA’s investor guidance on variable annuity exchanges tells owners to check when the surrender charges on the current contract expire and to consider how comfortable they are with a potentially longer surrender period on the new one, and warns that “Just because you can exchange your variable annuity doesn’t mean you should” (FINRA, Should You Exchange Your Variable Annuity?).

On the insurance side, the NAIC’s Suitability in Annuity Transactions Model Regulation (#275) was revised in 2020 so that “all recommendations by agents and insurers must be in the best interest of the consumer and that agents and carriers may not place their financial interest ahead of the consumers’ interest.” The NAIC reports that 48 states had adopted the revisions as of February 1, 2025 (NAIC, Annuity Suitability and Best Interest Standard).

Florida’s best interest duty on replacement recommendations

Florida adopted that standard in section 627.4554 of the Florida Statutes, titled “Suitability in annuity transactions.” The statute provides that an agent, when making a recommendation of an annuity, “shall act in the best interest of the consumer under the circumstances known at the time the recommendation is made, without placing the financial interest of the agent or insurer ahead of the consumer’s interest” (Florida Statutes § 627.4554).

Three features of the statute matter for a 1035 exchange specifically:

Exchanges are covered. A “recommendation” under the statute is advice intended to result in, or that does result in, a purchase, an exchange, or a replacement of an annuity. A 1035 exchange is squarely inside the statute, not adjacent to it.
Replacement is defined broadly. It reaches transactions in which a new annuity purchase causes an existing annuity to be surrendered, lapsed, converted to reduced coverage, amended to reduce benefits, reissued with reduced cash value, or used in a financed purchase.
Compensation must be disclosed. Before the sale, the agent must disclose the sources and types of cash and noncash compensation to be received, and on request must provide a reasonable estimate of the amount of cash compensation.

That last point is a right, not a courtesy. A Florida consumer considering an annuity exchange can ask the agent what the agent will be paid, and the agent has to give a reasonable estimate. Anyone who deflects that question is telling you something.

Florida’s 21-day free look on the new contract

Florida gives annuity purchasers a longer unconditional refund period than it gives life insurance purchasers. Under section 626.99(4)(b), with respect to fixed and variable annuities, the policy must provide an unconditional refund for at least 21 days. For fixed annuities the refund includes any contract fees or charges; for variable or market value annuities the purchaser receives the cash surrender value plus any fees or charges deducted, or a refund of all premiums paid (Florida Statutes § 626.99). By contrast, the same section contemplates a 14-day unconditional refund in the life insurance context.

Twenty-one days is enough time to read the contract you actually received rather than the illustration you were shown. Check the surrender charge schedule, the free-withdrawal percentage, the rider fees, and any rate or participation figures against what you were told. We cover the timing and mechanics in more detail in our guide to the Florida annuity free look period. If the contract does not match the pitch, the free-look window is the moment to act, not after it closes.

When an exchange holds up, and when it does not

An exchange is more likely to be defensible when the existing contract’s surrender period has already expired, when the new policy adds a feature the owner actually needs and the old one cannot provide, when total annual contract charges drop meaningfully, or when the owner’s objective has genuinely changed — for example, moving from accumulation toward guaranteed lifetime income, or exchanging into a qualified long-term care insurance contract to address care costs.

An exchange deserves more skepticism when the existing contract is still inside its surrender period and a charge would be incurred to leave, when the old contract carries a death benefit, guarantee or credited rate that would be forfeited, when the new contract’s advantage is a bonus or headline rate that is recovered through a longer surrender schedule, when the owner is likely to need liquidity within the new surrender period, or when a previous exchange happened within the last three years.

Questions worth asking before signing

What surrender charge, if any, applies to leaving the current contract today?
How many years is the new surrender schedule, and what is the charge in each year?
What benefits, guarantees or credited rates in the current contract are given up?
What are the total annual charges on each contract, including rider fees?
What compensation will you receive on the new contract? (In Florida you can ask for a reasonable estimate.)
Have I exchanged an annuity within the last 36 months?
What does the new contract do that the current one cannot?

Frequently asked questions

Can you do a 1035 exchange on an annuity?

Yes. The IRS permits the exchange of an annuity contract for another annuity contract, or for a qualified long-term care insurance contract. It does not permit exchanging an annuity contract for a life insurance policy. The transfer must move directly between the insurance companies.

Do you pay taxes on a 1035 exchange?

No income tax is due on the gain at the time of a properly executed exchange, and the issuing company reports the taxable amount as zero on Form 1099-R with distribution code 6. The tax is deferred, not forgiven: cost basis carries over, and the gain is taxed as ordinary income whenever it is eventually withdrawn. Confirm your own situation with a qualified tax professional.

What are the disadvantages of a 1035 exchange?

The main ones are a new surrender charge period on the new contract, a surrender charge on the old contract if it is still inside its own period, the loss of any benefits, guarantees or credited rates attached to the existing contract, and a new commission paid to the selling agent that creates an incentive to recommend the exchange. Fees on the new policy may also be higher.

Is a 1035 exchange a good idea?

It depends entirely on the two contracts and the owner’s circumstances, and no article can answer it for a specific person. FINRA’s framing is a useful test: the exchange should be better for you, not merely better for the person selling it. Compare surrender schedules, total charges, and benefits given up before deciding.

Can you do a partial 1035 exchange?

Yes. Part of an annuity contract’s value can be moved into a new annuity contract. Under Revenue Procedure 2011-38, the partial exchange receives automatic tax-free treatment only if no amount is received under either contract during the 180 days beginning on the transfer date, other than an amount received as an annuity for ten years or more or during one or more lives. Basis is allocated proportionally between the contracts.

Can multiple contracts be used in a 1035 exchange?

Insurance companies commonly accept the consolidation of more than one existing contract into a single new contract, and will also split one contract across more than one receiving contract. What is possible in a given case depends on the receiving company’s administrative rules, so confirm it before the paperwork goes in.

What is the difference between a replacement and a 1035 exchange?

“Replacement” is an insurance regulatory term for a transaction in which a new contract causes an existing one to be surrendered, lapsed or reduced. “1035 exchange” is a tax term for how the transfer is treated under the Internal Revenue Code. A 1035 exchange of an annuity is almost always also a replacement, which means Florida’s best interest requirements under section 627.4554 apply to the recommendation.

Do you have to report a 1035 exchange on your tax return?

You will generally receive a Form 1099-R showing the contract value in box 1, zero taxable in box 2a, premiums paid in box 5, and code 6 in box 7. Give it to whoever prepares your return. How it is reflected on the return itself is a question for a qualified tax professional.

Can the owner or annuitant change in a 1035 exchange?

Section 1035 treatment depends on the new contract being an exchange of the same owner’s contract rather than a new arrangement, so insurance companies generally require continuity of ownership, and changes to the parties on the contract can jeopardize the tax treatment. Raise any intended change with the insurance company and a qualified tax professional before the paperwork is submitted, not after.

Talking it through

If you hold a non-qualified annuity and someone has suggested exchanging it, the useful next step is a side-by-side comparison: current surrender schedule against proposed surrender schedule, current total charges against proposed total charges, benefits kept against benefits lost, and the compensation attached to the new contract. That comparison either supports the exchange or it does not. Lifeworth Insurance Agency will put it in writing either way, including when the recommendation is to leave the existing contract alone.

Disclosures

This article is general information about how Section 1035 of the Internal Revenue Code and related Florida insurance statutes operate. It is not tax, legal or financial advice, and it does not take account of any individual’s circumstances. Tax treatment depends on facts specific to you and to your contracts; consult a qualified tax professional before acting on anything described here.

Nothing in this article is a recommendation to exchange, buy, keep or surrender any annuity, insurance policy or other contract. Product features, charges and surrender schedules vary by contract and by state.

Annuity guarantees rest on the claims-paying ability of the issuing insurer. Annuities are not bank deposits, are not FDIC insured, and are not guaranteed by any federal government agency.

Lifeworth Insurance Agency is a trade name of Lifeworth Financial Group LLC, National Producer Number 21228343, licensed in Florida.

This article is part of Lifeworth’s annuities overview.