What Is a 1035 Exchange?
A tax-free transfer of an existing annuity contract for a new annuity contract, authorized under Internal Revenue Code Section 1035. The exchange defers all unrealized gains — no taxes are due at the time of transfer. The new contract inherits the original cost basis. Funds must transfer directly between insurance companies; the owner must never take constructive receipt of the money.
Think of a 1035 exchange as a tax-free lane change. You are moving your money from one annuity vehicle to another without pulling off the highway (which would trigger taxes). The IRS permits this because the money stays within the insurance system — you are simply changing the specific product, not cashing out.
The name comes from IRC Section 1035, which has permitted these exchanges since the 1954 Internal Revenue Code. It is one of the most underused tools in annuity planning, often saving owners thousands or tens of thousands of dollars in taxes that would otherwise be owed on a surrender-and-repurchase.
What qualifies for a 1035 exchange?
| From (Old Contract) | To (New Contract) | Allowed? |
|---|---|---|
| Annuity | Annuity (any type) | ✅ Yes |
| Life insurance | Annuity | ✅ Yes |
| Life insurance | Life insurance | ✅ Yes |
| Endowment | Annuity | ✅ Yes |
| Annuity | Life insurance | ❌ No |
| Non-qualified annuity | Qualified annuity (IRA) | ❌ No |
| Qualified annuity | Non-qualified annuity | ❌ No |
The rule is simple: you can move across or up in the insurance product hierarchy (life insurance → annuity), but not down (annuity → life insurance). And you cannot cross between qualified and non-qualified tax status.
Within the annuity category, any type can exchange to any other type: a variable annuity can become a MYGA, an FIA can become a SPIA, a MYGA can become a DIA — all tax-free.
How a 1035 Exchange Works: Step by Step
- Evaluate your current contract. Review: current value, cost basis (amount of after-tax money invested), surrender schedule, active riders or benefits, and the carrier’s financial strength. Identify specifically what you want to improve.
- Check the surrender schedule. If you are within the surrender period, calculate the exact charge. A 5% charge on $200,000 is $10,000. Is the new contract’s benefit worth that cost? If the surrender period ends within 1–2 years, waiting may be the better choice.
- Identify and compare the new contract. Get quotes from multiple carriers. Compare guaranteed rates or income amounts, fee structures, surrender periods, available features, and carrier financial strength (A.M. Best rating).
- Verify exchange eligibility. Same owner and annuitant on both contracts. Same tax qualification (non-qualified to non-qualified, or qualified to qualified). Permitted exchange direction.
- Submit paperwork through the new carrier. The receiving (new) insurance company initiates the 1035 exchange. They provide the exchange forms; you sign; they send to the old carrier. Critical: you must never request or receive a check. The funds must transfer directly between companies.
- Wait for the direct transfer. The ceding (old) company liquidates your contract and sends funds directly to the new carrier. Typically takes 2–6 weeks. Your cost basis carries over automatically.
- Review the new contract during the free-look period. Verify the correct amount was transferred, your cost basis is properly recorded, and contract terms match the quote. The free-look period (10–30 days) lets you cancel for a full refund if anything is wrong.
Tax Mechanics: What Carries Over
Cost basis carryover
The most important tax concept in a 1035 exchange is cost basis carryover. Your original investment amount (cost basis) transfers to the new contract. The gains transfer too — they are just deferred, not forgiven.
At the time of exchange: No taxes owed. The full $165,000 transfers to the new MYGA. Your cost basis in the new MYGA is $100,000 (carried over from the old contract). The $65,000 gain is deferred — not eliminated.
When you eventually withdraw from the MYGA: The $65,000 in gains (plus any additional growth in the MYGA) will be taxed as ordinary income using LIFO rules (gains come out first).
What a 1035 exchange does NOT do
- It does not forgive taxes. Gains are deferred, not eliminated. You will pay eventually.
- It does not reset your cost basis. The new contract inherits the old basis. You do not get a fresh $165,000 basis.
- It does not reset the annuity start date for the 59½ rule. If the original contract was purchased before age 59½, the new contract inherits that start date for penalty purposes.
- It does not waive surrender charges. If the old contract has a surrender charge, it applies to the transfer amount.
Tax reporting
The ceding (old) insurance company will issue a 1099-R with distribution code 6 (Section 1035 exchange), which tells the IRS this was a tax-free transfer, not a taxable distribution. No amount should appear in the taxable box. Keep this 1099-R for your records but no tax is due.
When a 1035 Exchange Makes Sense
Escaping High Fees
Moving from a high-cost variable annuity (2–3%+ annually) to a low-cost or no-fee product like a MYGA or FIA. A 2% fee reduction on $300,000 saves $6,000/year — $60,000+ over 10 years.
MOST COMMON REASONBetter Rates Available
Your MYGA is maturing and current market rates are higher (or you want a longer term). Exchange the maturing MYGA into a new one at the higher rate, tax-free.
MYGA RENEWALChanging Product Type
Moving from accumulation to income: exchange a MYGA or FIA into a SPIA or DIA for guaranteed lifetime income. Or moving from a variable annuity to a fixed annuity for safety. All tax-free.
LIFE STAGE SHIFTStronger Carrier
Your current carrier has been downgraded or you want to consolidate with a higher-rated insurer. A 1035 exchange moves your contract to a company with better financial strength.
RISK REDUCTIONBetter Features
Your current contract lacks a feature you now need — such as an income rider, better death benefit, or nursing home waiver. Exchange to a contract that offers it.
FEATURE UPGRADELife Insurance to Annuity
You no longer need life insurance coverage and want to convert the cash value into tax-deferred growth or retirement income. A 1035 exchange from life insurance to an annuity is tax-free.
COVERAGE CHANGEWhen a 1035 Exchange Does NOT Make Sense
✗ Do NOT Exchange If:
- You are still in a significant surrender period. A 6% surrender charge on $250,000 is $15,000. Unless the new contract saves more than $15,000 over its life, wait for the surrender period to expire.
- You have valuable legacy riders. Some older variable annuity contracts have GLWB riders with 6–7%+ roll-up rates or stepped-up death benefits that are no longer available in new products. These riders can be worth more than the annual fees you are paying. Once surrendered, they are gone forever.
- The improvement is marginal. Moving from a 4.50% MYGA to a 4.65% MYGA saves $150/year per $100,000. If the new contract starts a fresh 5-year surrender period, the marginal improvement may not justify the illiquidity.
- You are about to annuitize or start income. If you plan to activate a GLWB or annuitize within the next 1–2 years, the exchange disrupts that timeline and may reset benefit calculations.
- The new contract is not clearly better. Never exchange simply because an agent suggests it. The new contract must solve a specific problem: lower fees, better rate, needed features, or stronger carrier. “It’s newer” is not a reason.
- You have very small gains. If your contract has minimal gains (e.g., $2,000), a simple surrender and repurchase may be more practical. The tax on $2,000 of ordinary income may be less hassle than the 1035 paperwork and 2–6 week transfer process.
Partial 1035 Exchanges
You do not have to exchange your entire contract. A partial 1035 exchange allows you to transfer a portion of your annuity’s value to a new contract while keeping the rest in the existing one. This was clarified by IRS Revenue Procedure 2011-38.
How it works
You specify the dollar amount or percentage to transfer. That portion moves directly to the new contract (tax-free), and the remainder stays in the old contract. The cost basis is split proportionally between the two contracts.
Result: The SPIA receives $150,000 with a cost basis of $100,000 (50% of original basis). The FIA retains $150,000 with a cost basis of $100,000 (remaining 50%). No taxes due on either portion.
The 180-day rule
The IRS requires that you take no withdrawals from either the old or new contract within 180 days of the partial exchange. Violating this rule may cause the IRS to recharacterize the exchange as a taxable distribution. Mark the date and do not take any withdrawals from either contract during the 180-day window.
When partial exchanges are useful
- Splitting accumulation and income: Keep part of your FIA growing while moving a portion to a SPIA for current income
- Diversifying carriers: Move half your contract to a different insurer without triggering taxes
- Gradual transition: Move incrementally over several years rather than all at once
- Preserving a valuable rider: Keep the portion of the contract with the legacy rider while exchanging the rest to a better product
1035 Exchange Pitfalls to Avoid
| Pitfall | What Happens | How to Avoid |
|---|---|---|
| Taking constructive receipt | IRS treats it as a taxable surrender. You owe ordinary income tax on all gains + possible 10% penalty. | Never receive a check. Funds must transfer directly between companies. |
| Ignoring surrender charges | Old contract deducts the charge from transferred amount. You arrive at the new contract with less money than expected. | Check your surrender schedule before initiating. Calculate the exact dollar impact. |
| Losing legacy riders | Valuable GLWB, GMDB, or other riders on the old contract are permanently lost. New contract may not offer comparable terms. | List every rider on your current contract and its terms. Have an agent confirm whether comparable benefits exist in the new product. |
| Starting a new surrender period | Even if your old contract’s surrender has expired, the new contract starts its own (typically 3–10 years). | Factor the new surrender period into your decision. If you may need liquidity soon, a shorter surrender or no-surrender product may be better. |
| Mismatched ownership | Exchange is invalid if the owner or annuitant changes between old and new contracts. | Verify same owner and annuitant on both contracts before submitting paperwork. |
| Crossing tax qualification | Exchange is invalid if moving between non-qualified and qualified (or vice versa). | Non-qualified stays non-qualified. Qualified stays qualified. No crossing. |
| Violating the 180-day rule (partial) | IRS may recharacterize partial exchange as taxable distribution. | No withdrawals from either contract within 180 days of a partial exchange. |
Common 1035 Exchange Scenarios
Variable Annuity → MYGA
The most common exchange. Owner escapes 2–3%+ annual fees in the VA and locks in a guaranteed rate with zero fees. Makes sense when: the VA’s surrender period has ended, no valuable legacy riders exist, and the owner wants simplicity and safety. The fee savings alone can be $5,000–$15,000+ per year on larger contracts.
Maturing MYGA → New MYGA
When a MYGA reaches the end of its guarantee period, the renewal rate is often lower than rates available from other carriers. A 1035 exchange to a new MYGA at a higher rate is straightforward and carries no surrender charges (since the old MYGA has matured). This is a routine optimization that should be evaluated at every MYGA maturity.
Accumulation Annuity → Income Annuity (SPIA or DIA)
Moving from a growth phase to an income phase. A MYGA or FIA is exchanged for a SPIA (immediate income) or DIA (future income). The full accumulated value transfers tax-free, and the income annuity uses the carried-over cost basis to calculate the exclusion ratio for non-qualified contracts. This is the cleanest way to transition from saving to spending.
FIA → Better FIA
An older FIA with low caps or unfavorable crediting methods can be exchanged for a newer contract with better terms. Be cautious: check whether the old FIA has an income rider with legacy terms that cannot be replicated. If it does, the rider value may exceed the benefit of better caps.
Life Insurance → Annuity
An older life insurance policy with significant cash value can be exchanged for an annuity when the owner no longer needs the death benefit. This converts the cash value into tax-deferred growth or immediate income. The annuity inherits the life insurance policy’s cost basis.