1035 Exchange
An IRS provision, Section 1035, permitting the tax-free exchange of one annuity contract for another.
A 1035 exchange is a provision of Internal Revenue Code Section 1035 that lets an owner move funds from one annuity contract directly into another without triggering a taxable event at the time of transfer. The tax basis and deferral carry over to the new contract. It is a tax mechanism only - it does not waive surrender charges, market value adjustments, or the loss of features in the contract being replaced.
- —The transfer must go carrier-to-carrier. Taking a distribution and re-depositing it does not qualify.
- —A 1035 exchange defers tax; it does not eliminate it. Cost basis and gain carry into the new contract.
- —Surrender charges and market value adjustments on the old contract still apply.
- —A new contract typically starts a new surrender period, which is the most commonly overlooked consequence.
Gain and cost basis carry over into the new contract instead of being recognized in the year of the transfer. An annuity may be exchanged for another annuity, and a life policy for an annuity, but not the reverse.
Tax-free is not cost-free. Any surrender charge still in force may apply, riders generally do not travel with the money, and the new contract starts its own surrender schedule.
What qualifies and what does not
Section 1035 permits specific directions of exchange between life insurance, endowment, and annuity contracts. Annuity to annuity qualifies. Life insurance to annuity qualifies. Annuity to life insurance does not.
The owner and the annuitant generally must remain the same across the exchange, and the transfer must be executed directly between carriers using the receiving carrier's transfer paperwork.
| From | To | Qualifies under Section 1035 |
|---|---|---|
| Annuity | Annuity | Yes |
| Life insurance | Annuity | Yes |
| Annuity | Life insurance | No |
| Annuity | Long-term care (qualified) | Yes, subject to specific requirements |
| Qualified (IRA) annuity | Another IRA annuity | Handled as a trustee-to-trustee transfer, not a 1035 |
The costs a 1035 exchange does not remove
Because the tax treatment is favourable, an exchange can be presented as though it is cost-free. It is not. Anything in the surrendered contract that is time- or contract-dependent is still assessed or forfeited at the moment of transfer.
- —Surrender charges remaining on the old contract are deducted from the amount transferred.
- —A market value adjustment may increase or reduce the transferred amount.
- —Riders, enhanced death benefits, bonus recapture provisions, and accumulated benefit-base roll-up in the old contract are generally forfeited.
- —Legacy contracts sometimes carry guaranteed minimum rates far above anything currently available; those are lost permanently.
- —The new contract usually begins a fresh surrender period, restarting the liquidity clock.
When an exchange is worth examining
There are situations where the arithmetic clearly favours a review: a contract past the end of its surrender period sitting in a low renewal rate, a rider being paid for but structurally unusable, or a carrier whose financial strength rating has moved materially since issue.
There are equally clear situations where it does not: an owner still deep in a surrender schedule, a legacy guaranteed rate that cannot be replaced, or a benefit base that has accrued substantial value that would be surrendered.
Every state requires replacement disclosure paperwork precisely because the decision has consequences that are not obvious from an illustration. A licensed professional should compare the contracts side by side before anything is signed.
Frequently asked questions
- Does a 1035 exchange cost anything?
- The tax treatment itself has no cost, but the surrendered contract's surrender charge and any market value adjustment are still assessed, and features unique to the old contract are forfeited. Those are the real costs of an exchange.
- How long does a 1035 exchange take?
- Carrier-to-carrier transfers commonly take two to six weeks depending on both carriers' processing and whether the contract is held in trust or has assignment complications.
- Can I do a partial 1035 exchange?
- Partial exchanges are permitted, but the IRS applies specific rules to subsequent withdrawals from either contract within a defined period after the transfer. This is a scenario where tax advice before acting matters.
- Is a 1035 exchange the same as a rollover?
- No. A 1035 exchange applies to non-qualified contracts held with after-tax money. Moving an IRA annuity to another IRA annuity is a trustee-to-trustee transfer governed by retirement account rules, not Section 1035.