What Is a 1035 Exchange? Tax-Free Annuity and Insurance Transfers

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A 1035 exchange is a tax-free swap of one life insurance policy, annuity, endowment or qualified long-term care contract for another, permitted under Section 1035 of the Internal Revenue Code. When the exchange follows the rules, the gain built up inside the old contract is not taxed at the time of the swap. The tax is deferred into the new contract, and the old contract’s cost basis carries over with it.

Variable, fixed and indexed annuities are all annuity contracts for Section 1035 purposes, so an owner can exchange one for another in any direction: variable to fixed, fixed to variable, variable to indexed, or one variable annuity to another.

How a 1035 Exchange Works

The exchange must be like for like in the direction the code allows. Permitted swaps include:

1. Life insurance to life insurance
2. Life insurance to an annuity
3. Life insurance to an endowment
4. Endowment to an annuity
5. Endowment to endowment (as long as payments do not start later than under the old contract)
6. Annuity to annuity
7. Life insurance or a non-qualified annuity to a qualified long-term care contract, an option added by the Pension Protection Act of 2006

The logic behind the one-way rules is that you can move toward a contract with less tax-free death benefit, but not toward one with more. An annuity cannot become life insurance because that would turn deferred, taxable gain into a potentially tax-free death benefit.

Two procedural conditions apply to every exchange:

• Direct transfer. The owner cannot cash out and then buy the new contract. IRS guidance in Revenue Ruling 2007-24 treats a check paid to the owner and later reinvested as a taxable surrender, not an exchange. There is no 60-day rollover window as there is for some retirement accounts.
• Same owner and annuitant or insured. An annuity owned by one spouse cannot be exchanged into an annuity owned by the other spouse, into a jointly owned contract or into a trust. A change in ownership is a separate transaction with its own tax consequences.

Full and partial exchanges

A full exchange moves the entire contract value and the entire cost basis. In a partial exchange, only part of the value moves to a new contract, and basis is generally allocated between the old and new contracts in proportion to the value transferred. Insurers set their own rules on whether they accept partial exchanges, so terms vary by company.

Example of a 1035 Exchange

Hypothetical example 1: a loss carries forward. An investor puts $100,000 into a non-qualified variable annuity and takes no withdrawals or loans. Poor performance drops the value to $75,000. She exchanges into a fixed annuity at another insurer. The new contract holds $75,000, but its cost basis is $100,000. If she later withdraws everything when the contract is worth, say, $95,000, she has no taxable gain, because the value never exceeded her basis.

Hypothetical example 2: a gain stays deferred. Another owner paid $60,000 into an annuity now worth $90,000. Surrendering it would make the $30,000 gain taxable as ordinary income. Through a 1035 exchange, the full $90,000 moves into the new annuity with a $60,000 basis. The $30,000 gain remains untaxed until withdrawals or a surrender from the new contract.

Costs and Benefits

The main benefit is flexibility without a tax bill. An owner can leave an older or underperforming contract for one with different investment options, guarantees, lower ongoing fees or fewer restrictions. Someone who no longer wants market exposure in a variable annuity can lock in a fixed rate, and a policyholder who no longer needs a death benefit can turn cash value into an income-producing annuity.

The exchange does not erase obligations under the old contract:

• Surrender charges. Insurers typically do not waive surrender charges because a transfer is a 1035 exchange. Some may waive fees when the new contract is issued by the same company.
• New surrender period. The replacement contract may carry its own surrender schedule, restarting the time you are locked in.
• Lost features. Riders, guaranteed minimum benefits, favorable rates or death benefit guarantees on the old contract usually end when it is surrendered.
• Policy loans. If a life insurance policy with an outstanding loan is exchanged and the loan is paid off in the process, the extinguished loan can be treated as taxable “boot.”

What Does Not Qualify

Exchanges in the disallowed direction (annuity to life insurance, endowment to life insurance, annuity to endowment), changes in owner or annuitant, and indirect transfers all fall outside Section 1035 and are taxed accordingly. Annuities held inside IRAs, 401(k)s or other qualified plans also do not use a 1035 exchange. They move by trustee-to-trustee transfer or rollover under retirement account rules. The “external non-qualified 1035 exchange” label applies to annuities bought with after-tax money and moved to a different insurer.

Reporting a 1035 Exchange

A 1035 exchange is reportable even though it is not taxable. When funds move from one company to another, the transferring insurer issues Form 1099-R showing the amount transferred and distribution code 6, which identifies a Section 1035 exchange. An exchange within the same company may not generate a 1099-R at all.

1035 Exchange vs. Replacement vs. 1031 Exchange

Every 1035 exchange is a replacement, but not every replacement is a 1035 exchange. Exchanging a life insurance policy into an annuity is both. Swapping an annuity into a life insurance policy is a replacement only: the old contract is treated as surrendered, and gain or loss is recognized.

A 1031 exchange is a different code section entirely. Section 1031 covers like-kind exchanges of business or investment real estate and does not apply to annuities or insurance. Section 1035 covers insurance and annuity contracts and does not apply to property.

FAQs

The Bottom Line

Owners of annuities or life insurance who want different guarantees, investments or fees can switch contracts without an immediate tax bill. The old contract's cost basis carries over, so a loss can shelter future gains and an existing gain stays deferred. Before exchanging, compare surrender charges, a possible new lock-in period and any riders or guarantees that would end with the old contract.