1035 Exchange for Annuities: Rules and How It Works (2026)

What is a 1035 exchange?

Section 1035 of the Internal Revenue Code lets you trade one insurance or annuity contract for a new one without triggering tax on the gain built up inside the old one. Without that rule, cashing out an older annuity to buy a better one would mean paying tax on every dollar of growth first. A 1035 exchange keeps that growth compounding inside the new contract instead of handing part of it to the IRS on the way out.

The rule only protects a direct, contract-to-contract transfer. The old carrier sends your funds straight to the new one. Take a check yourself first and then buy a new policy with the proceeds, and the transaction no longer qualifies. It gets taxed as an ordinary withdrawal instead.

Say your original annuity has grown from a $100,000 deposit to $140,000. Cash it out on your own and that $40,000 of gain is taxable income the year you receive it. Route the same $140,000 through a 1035 exchange into a new contract and none of that gain is taxed today. Your cost basis, the $100,000 you originally put in, carries over to the new contract, and the deferred gain stays deferred until you eventually take money out of whichever contract you end up with.

What a 1035 exchange can and cannot do

The tax code limits which contracts you can trade tax-free:

• A life insurance policy can move into another life insurance policy.
• A life insurance policy can move into an annuity.
• An annuity can move into another annuity.
• An annuity cannot move into a life insurance policy. That direction is off the table under Section 1035.

The Pension Protection Act of 2006 added one more path: you can now use a 1035 exchange to fund a qualified long-term care policy with annuity value. See our guide to LTC annuities if that combination interests you.

Not every policy swap qualifies, even if people call it one. The industry uses the broader term "replacement" for any deal where a new policy is funded from an old one, and a 1035 exchange is just one specific, tax-free flavor of replacement. Plenty of replacements fail the IRS test and end up taxed as a surrender followed by a fresh purchase, so never assume a trade-in is automatically tax-free.

How the paperwork actually works

You don't call your old carrier and ask for a check. Your new application instead gets bundled with two additional forms.

The first is the 1035 exchange form, usually two pages: one page of legal disclosures, and a second asking for details on the policy you're leaving, including the carrier's name, your policy number, the type of annuity, and the company's address and phone number.

The second is a replacement form, typically also two pages, which most states and carriers require any time a new policy is meant to replace an existing one. Insurers use it to compare the two contracts side by side and confirm the swap actually serves you, not just a new commission.

Once your application and both forms are in, the money transfers directly from one insurer's custodian to the other's. You never touch it, and that's exactly what preserves the tax deferral.

Plan for the process to take longer than opening a brand-new contract with fresh money. Two insurance companies, each with their own paperwork queue and verification steps, have to coordinate the transfer, and the carrier you're leaving generally has little reason to move quickly on a request that reduces their assets. Ask your new carrier or licensed strategist for a realistic timeline up front rather than assuming it will close in a few days.

Why buyers request a 1035 exchange

People pursue an exchange for concrete reasons, not tax strategy for its own sake:

• They need more life insurance coverage than their current policy carries.
• They want a different type of life insurance altogether.
• They found an annuity with lower fees.
• They want their annuity income restructured on a different schedule.
• They own a variable annuity and their appetite for market risk has changed.

Before signing anything, it's worth working through a short list of questions: What were you originally trying to accomplish with this contract? Has that goal shifted? Does the new contract genuinely beat the old one on rate, fees, the death benefit, or lifetime income? And is the existing contract still inside its surrender period, or are you already free to move without a penalty? Our page on surrender charges breaks down how those penalties get calculated.

What a 1035 exchange costs

The exchange itself carries no IRS fee. Any cost comes from the contract you're leaving. If it's still inside its surrender period, most carriers apply the same surrender charge to a 1035 exchange that they'd apply to any other large withdrawal. Few insurers waive it simply because the destination is a 1035.

One exception: some carriers let you move between their own products without a surrender charge, usually called an internal exchange rather than a 1035, and governed by the carrier's own rules rather than the IRS. Separately, almost every deferred annuity lets you annuitize, meaning convert the balance into an income stream, during the surrender period without a charge, even though a lump-sum withdrawal in that same window would trigger one.

Partial 1035 exchanges

You don't have to move the entire contract at once. A partial 1035 exchange splits your cost basis and gain proportionally between the old contract and the new one. Because that split creates an opening for abuse, the IRS layered on an extra rule.

To keep a partial exchange tax-free, avoid pulling any money out of either policy for the first 180 days after the transfer closes. Withdraw early and the IRS can fold that withdrawal back into the original transaction rather than treating it as separate, which makes the entire amount taken from both contracts taxable, not just the slice tied to the policy you actually drew from.

There's one carve-out: the 180-day rule doesn't apply if the distribution comes out as lifetime income or as a stream of payments running 10 years or longer.

Because a partial exchange divides your basis between two contracts, keep a copy of the exchange paperwork and the resulting basis allocation for both policies. Your new carrier's tax reporting will rely on that split years down the road, and it's far easier to confirm the numbers at the time of the exchange than to reconstruct them from memory when you eventually take a withdrawal. Talk with a tax professional before executing a partial exchange, since the 180-day rule and the basis math both have real consequences if they're handled incorrectly.