If you’re holding an underperforming annuity contract, dealing with sky-high fees or just looking for an annuity that better suits your needs, a 1035 exchange could be your ticket to better terms without triggering taxes.
Section 1035 of the Internal Revenue Code lets you swap one annuity for another, tax-free. When done right, this helps you bypass capital gains tax or income tax on your accumulated growth.
The potential benefits are real: Better rates, lower fees, stronger riders and more control over your retirement income. But there are downsides to consider, too. You could lose current benefits, reset the clock on surrender charges or lock yourself into a contract that’s worse in the long run.
Here’s everything you need to know about 1035 exchanges, along with factors you should consider before making the switch.
How to transfer an annuity with a 1035 exchange
A 1035 exchange lets you transfer your current non-qualified annuity — meaning an annuity that wasn’t funded with IRA or 401(k) money — to a new annuity without paying taxes on the gains. The key term here is “non-qualified.” If your annuity is inside a retirement plan, different rules apply and you can’t use a 1035 exchange.
For the exchange to work, you can’t simply cash out your old annuity and put the money in a new one yourself. That would be considered a full surrender and would trigger taxes and penalties.
Instead, your new annuity company initiates the exchange directly with your old provider. They coordinate everything behind the scenes — a similar process to rolling over a 401(k).
You’ll usually fill out a 1035 exchange form provided by the new insurance company. The form will ask for information about your current annuity and the company holding it.
Then, once approved, your old annuity is liquidated and the cash is moved directly to the new contract. This is often called a “like-kind exchange,” which essentially means you’re not cashing out, just swapping contracts.
The new contract can be held by a different insurance company or with the same one. What matters is that the owner and annuitant stay the same. If you change either one, the IRS could see it as a taxable distribution.
You can also switch between different types of annuities. So if you’re holding a variable annuity, for example, and want to move into a fixed annuity or a fixed indexed annuity, that’s all fair game under Section 1035. What matters is that it’s an exchange between “like-kind” insurance contracts — meaning they’re both annuity contracts, even if they work differently.
Finally, if you’re transferring to a new contract with better terms, make sure those benefits truly outweigh any costs or penalties associated with leaving your old annuity.
When exchanging an annuity makes sense
There are several instances when it can make sense to exchange an old annuity for a new one.
For example, maybe you bought your current annuity years ago when interest rates were low. Or maybe the contract is saddled with high fees and subpar investment options. Or maybe you’ve had a major life event and need more flexibility or income guarantees. In those cases, opting for a different contract might be a smart move.
Ultimately, the transfer should improve your financial position without jeopardizing your tax deferral status. The idea is not simply switching, but upgrading with intention.
Here are some other situations when it can make sense to do a 1035 exchange:
- Your current annuity has high annual fees that are eating into your returns.
- The interest rate or investment performance of your current contract is lackluster.
- You want to add a rider, such as guaranteed lifetime income or long-term care coverage, that your current insurer doesn’t offer.
- You’re simplifying your finances and consolidating multiple annuities into one.
- Your current insurance company has poor financial ratings or customer service.
When exchanging an annuity doesn’t make sense
There are times when a 1035 exchange can do more harm than good. Just because the process is tax-free doesn’t mean it’s free from other consequences. If you’re not careful, you could lose more in fees, penalties and benefits than you gain with a new contract.
One of the biggest red flags is surrender charges.
Many annuities come with a surrender period — usually five to 10 years — during which you’ll pay a hefty penalty if you pull your money out early. If you’re still in that surrender period window, the cost to exit might wipe out any gains from switching. The new contract might have shinier features, but those won’t help if you’re losing money on the way out.
Also, not all annuities are better simply because they’re newer. Some financial professionals and insurance brokers push exchanges because they get a commission, not because it’s in your best interest. Don’t fall for marketing hype. If the new product doesn’t clearly beat your current one on fees, performance or flexibility, don’t make the switch.
Weighing your options with a financial advisor can be beneficial if you’re thinking about a 1035 exchange.
Taxes and other considerations
A properly executed 1035 exchange is tax-free. You’re not cashing out — you’re simply rolling one annuity into another. You keep the original cost basis and any gains continue to grow tax-deferred.
However, if you mess up the transfer process, it can trigger taxes. If the funds ever hit your bank account — you withdraw the money and try to deposit it yourself, for example — that’s no longer a 1035 exchange. That’s a taxable distribution. You’ll owe ordinary income tax on any growth in the annuity, and if you’re under age 59½, you may also get hit with a 10 percent early withdrawal penalty from the IRS.
It’s worth noting that while the exchange itself isn’t taxable, it usually restarts the surrender period on the new contract. That means you could be locked in another five to 10 years before you can exit penalty-free. Make sure the terms of the new annuity are worth the wait.
Other things to consider before pulling the trigger on a 1035 exchange:
- You might lose grandfathered benefits (such as death benefits or payout rates) by ditching your old contract.
- Some contracts have waiting periods before new riders kick in.
- You might lose any bonus interest if you give up your current annuity.
- You can’t change the owner or annuitant without creating a taxable event.
- You may be required to pay surrender charges to exit your current annuity.
Should you exchange your annuity?
Exchanging your annuity isn’t a one-size-fits-all decision. A 1035 exchange can be a smart move if your current annuity is no longer meeting your needs, but you need to weigh the pros and cons.
Start by assessing your goals. Are you trying to boost income, get better investment options or lower your costs? Does the new annuity actually solve a problem you have right now, or is it just newer and different? Be honest about your motivations and skeptical of anyone who benefits from getting you to switch.
One of the best things you can do is speak to a fiduciary financial advisor — not a commission-based insurance salesperson. Someone who isn’t incentivized to sell you a new contract can help you do a side-by-side comparison and run the numbers objectively. And if you’re managing this as part of your retirement plan, think about how the change impacts the bigger picture, not just the annuity itself.
Bottom line
A 1035 exchange is one of the few legal ways to swap one annuity for another without triggering a tax headache down the road. But it’s not a hack or loophole — it’s a strategic move that needs to be executed correctly.
If your current annuity is dragging you down, exploring an exchange could be a smart step. But don’t let FOMO or smooth-talking salespeople steer the wheel. Run the numbers, read the fine print and make sure the switch truly improves your financial situation.
Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.
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