The 1035 Exchange: Swapping One Annuity for Another, Tax-Free

A 1035 exchange lets you move money from one annuity contract into another without paying income tax on the gain. Section 1035 of the Internal Revenue Code treats it as an exchange rather than a sale, so the money travels carrier to carrier and you never take receipt of it. Your cost basis carries over.

There are two ways to get out of a car you no longer want. You can sell it, take the cash, pay whatever the sale costs you, and then go buy a different one. Or you can drive it to a dealer and trade it in, where the value of the old car moves sideways into the new one and never becomes cash in your hands at all.

A 1035 exchange is the trade-in. Congress wrote it into the tax code so that people whose insurance or annuity needs changed would not be punished with a tax bill just for switching contracts. The gain rides along into the new contract, untaxed, and keeps deferring until you actually take money out.

The mistake people make is assuming the trade-in solves everything. It solves the tax problem. It does not solve the contract problem, and the difference between those two is most of what you need to know before you sign anything.

What is a 1035 exchange?

It is a tax-free exchange of one insurance or annuity contract for another, authorized by Section 1035 of the Internal Revenue Code. Because it is structured as an exchange rather than a surrender followed by a purchase, no gain is recognized at the time it happens.

Which swaps does Section 1035 allow?

Not every combination qualifies, and the rules run in one direction more than the other. Here is the map.

The asymmetry is deliberate. You can trade a life insurance policy for an annuity, but you cannot trade an annuity for life insurance. If someone proposes moving your annuity into a life policy as a tax-free exchange, that is your signal to stop and get a second opinion.

Does a 1035 exchange erase the surrender charge?

No. This is the single most common misunderstanding about exchanges, and it is expensive. Section 1035 addresses the tax code. It has no authority over the contract you signed with the insurer.

• The surrendering carrier applies whatever its schedule calls for, exactly as it would on a cash surrender.
• Any market value adjustment in the old contract applies too, and it can cut either direction depending on where rates have moved.
• The new contract almost always starts a fresh surrender schedule, usually at the top step.
• Some carriers offer a bonus or enhanced rate to offset an exchange cost. Read what that bonus costs elsewhere in the contract before you weigh it.
• What transfers is the money and the basis. Not the elapsed time, not the schedule, not any rider you liked.

Run the arithmetic before the paperwork. Our guides to annuity surrender charges and surrender periods show how to price the exit, and the number that matters is your surrender value in writing from the current carrier, effective on a specific date.

What is a partial 1035 exchange?

It is an exchange of only part of one annuity’s cash value into a second contract, and the IRS permits it under conditions set out in Revenue Procedure 2011-38. The rules are stricter than for a full exchange, because a partial exchange looks a lot like a withdrawal if you squint.

Rev. Proc. 2011-38 shortened the waiting period that had applied under the earlier Rev. Proc. 2008-24, cutting it from 12 months to 180 days. If you find older guidance online quoting a one-year window, it has been superseded.

How does the paperwork actually work?

Five steps, and the order protects you. Every one of them exists to keep the money from touching your hands.

When is a 1035 exchange a bad idea?

When the cost of leaving is larger than the benefit of arriving. Check yourself against this list before you start.

• You are deep in a surrender schedule. Paying 5 or 6 percent to chase a rate improvement of half a point rarely pencils out.
• You would lose a rider you are actually using. Guaranteed lifetime withdrawal benefits and enhanced death benefits do not travel. Some older contracts carry guarantees that current products do not offer.
• The new contract’s surrender period is longer than your horizon. A fresh staircase on money you may need in four years is a bad trade at any rate.
• The only reason is a bonus. Ask what the bonus costs in caps, participation rates, or a longer schedule.
• You have not seen the numbers in writing. Current surrender value, new contract rate and term, new surrender schedule, and any market value adjustment. If someone will not put those four in writing, that is the answer.
• Your contract is close to maturity. Waiting out a few months can beat any exchange. Our guide to MYGA maturity options covers the renewal window.

When does a swap beat surrendering for cash?

Almost always, if you are staying in an annuity at all, because surrendering triggers tax on the entire gain in one year while an exchange defers it.

Those figures are a snapshot of what carriers had filed on that date, and the MYGA rates pages refresh as new filings land. They are useful for one purpose here: sizing whether a rate improvement is big enough to justify an exit cost. Read them with two qualifications. Rates vary by state and by minimum premium, so the top figure may not be available to you. And the highest rate in any term is frequently filed by a carrier with a lower AM Best financial strength rating than the next name down the list, which is why the rates pages show the carrier, product, and rating behind every figure rather than a bare number. Any guarantee in a new contract rests on the claims-paying ability of the issuing insurer. These contracts are not FDIC insured and are not backed by a bank or the federal government, so carrier strength belongs in the comparison alongside the rate.

The honest case against exchanging at all: a contract that is doing its job, at a rate you accepted, with a schedule that is running down every year, is often best left alone. The industry sells exchanges. Nobody earns anything when you wait.

Moving forward

Back to the trade-in. The value moves sideways into the new vehicle and never becomes cash, which is exactly why the tax bill never arrives. That is the whole elegance of Section 1035, and it is worth using whenever you are moving from one annuity to another.

Just do not confuse the tax mechanism with the decision. Price the exit first, in writing. Then compare it to what is actually available on current annuity rates and across our product overview. If the improvement does not clearly cover the cost of leaving, the answer is to wait, and waiting is a real answer. For the tax mechanics on the contract you are leaving, our guide to non-qualified annuity taxation explains what the gain would cost you if you surrendered instead.

Frequently asked questions