How to do an annuity 1035 exchange, step by step

A section 1035 exchange lets you move an annuity into a new annuity without paying income tax on the gain at the time of the move. It only works if the money goes straight from one insurance company to the other and you never hold it. The tax is deferred, not forgiven, and the move can cost you surrender charges, guarantees and time, so the paperwork is the easy part. This walkthrough follows one hypothetical exchange from the first question to the last confirmation letter, with the points where it most often goes wrong.

For the rules behind the exchange itself, including what can be swapped for what, see the guide on 1035 exchanges: swapping policies without tax. This post covers only the annuity-to-annuity case and treats it as a process.

What the exchange is, in two paragraphs

Under section 1035 of the Internal Revenue Code, an annuity contract can be exchanged for another annuity contract, or for a qualified long-term care contract, without recognizing gain or loss, provided the exchange is of one contract for another and the owner stays the same. Your cost basis, the after-tax money you put in, carries over to the new contract. The gain also carries over and is taxed later, as ordinary income when withdrawn.

Two features of the rule drive the whole process. First, the transfer must be made directly between the companies; if the check is made out to you and you deposit it, the old contract has been surrendered and the gain is taxable that year. Second, the exchange runs one way for annuities: an annuity can become another annuity or a long-term care contract, but not a life insurance policy.

Step 1: write down the reason before you start

Begin with a sentence you could say to a friend: "I want to move because ..." Common honest reasons include a lower ongoing fee, a feature the old contract lacks, such as a different investment menu, a concern about the old company or a contract that is about to expire its term. Weak reasons include "the agent says it's better" and "there is a bonus." A bonus is a cost in disguise, as the post on premium bonus annuities: how the bonus gets paid for explains.

If you cannot state the reason in a sentence, stop here. Replacement is the most common source of complaints about annuity sales, and a new commission is sometimes the real engine behind a recommendation. The guide on twisting and churning: replacement sales abuses describes what that looks like.

Step 2: collect the old contract's numbers

Ask the current company for a written statement showing:

• the current account value and the cash surrender value, which is what you would receive after any charges;
• the cost basis, so you know how much of the value is gain;
• the surrender charge schedule and the percentage that applies today;
• any market value adjustment, and whether an exit now would raise or lower the value;
• the free-withdrawal amount for the year;
• any riders, with their current benefit base and what would end if the contract ended;
• the death benefit, with the formula.

The company has a duty under replacement rules in most states to give an existing-contract statement when a new insurer asks for one, but you can request it yourself, and having your own copy keeps the comparison honest. A form to authorize the release of this information may be needed. For a more detailed list of what to look for, see the post on before you replace an annuity: what to check about what you lose.

Step 3: confirm the account type and the roles

Which kind of annuity is it

Is the annuity non-qualified (bought with after-tax money) or qualified (inside an IRA or another retirement plan)? The answer decides which tool you use.

• Non-qualified: a 1035 exchange is the tool.
• Qualified, inside an IRA: the tool is a trustee-to-trustee transfer, which is a different mechanism with its own forms. A 1035 exchange does not apply, because the money already sits inside a tax wrapper. The practical steps are similar.
• Inside an employer plan: the plan's rules decide whether any move is possible, and the plan administrator is the first call.

Do not use the words "1035 exchange" on a form for a retirement-account annuity. The wrong form can delay the transfer or be treated as a distribution.

Check that owner and annuitant match

The exchange rules expect the same taxpayer on both sides. The new contract should have the same owner, and in most cases the same annuitant, as the old. Listing a spouse as an additional owner, or changing the annuitant for convenience, can disqualify the exchange or draw questions from the new insurer. If a change is wanted, make it after the exchange is complete and after asking a tax professional. If you are unsure of the roles, the post on owner, annuitant, beneficiary: how three roles change what happens at death explains them.

Step 4: compare the new contract honestly

Ask the agent or the new company for the contract specimen, the surrender schedule, the fee schedule and the rider terms in writing. Then compare the two contracts line by line.

A useful hypothetical shows how the numbers can look. Say your old non-qualified annuity is worth $120,000. You paid $90,000 in premiums, so your basis is $90,000 and your gain is $30,000 ($120,000 minus $90,000). The old contract still has a 3 percent surrender charge, which applies to $120,000 minus a free withdrawal you might take. To keep the arithmetic simple, assume the charge applies to the full amount: 3 percent of $120,000 is $3,600, so $116,400 is available to move.

The new contract credits, say, 0.5 percentage points more per year, an assumption you would need to see in writing and which may not last. Half a percentage point on $116,400 is $582 a year. Dividing the $3,600 charge by $582 gives about 6.2 years before the extra interest has paid the charge back, even before counting anything else. If the new contract starts a fresh seven-year surrender period, you would be committed for longer than it takes to break even. The numbers are invented, but the method works for real ones: add the cost of leaving, divide by the yearly benefit, and compare the result with the new lock-up period. The keep, surrender or sell your policy? is built for life policies, but the same thinking applies.

Beyond the numbers, check for lost guarantees. A guaranteed minimum rate on the old contract may be higher than anything in the new one, and an income rider's benefit base cannot be moved: it stays behind. Also compare the death benefit and the fees (annuity surrender charges and free withdrawals covers the schedule, and the guide on annuity fees, explained covers the rest).

Step 5: apply, and complete the replacement paperwork

The new company will ask you to complete an application and, because you hold an existing contract, a replacement form. Most states have replacement rules based on a model regulation, under which the agent must disclose that a replacement is occurring, list the existing contracts and leave you with the sales material. The new company usually notifies the old one, which may then contact you to discuss the move. Do not treat that call as hostile. It is part of the safeguard, and it is also a chance for the old company to offer a retention deal, which you should compare in the same way.

Read each form before you sign. Do not sign anything blank. Keep copies of what you sign.

Step 6: complete the exchange request

In a typical process, the new company supplies a transfer or exchange request form, often called a 1035 exchange form. You fill in your information, the old contract number and the new one, and sign. The new company sends the form to the old company, and the old company sends the money by wire or check to the new company, not to you.

Points to check on the form:

1. The name of the owner matches exactly on the old and new contracts.
2. The request is marked as a full exchange or a partial one. Partial exchanges are allowed under IRS guidance, but they have extra rules about withdrawals soon after the exchange and should be arranged with a tax professional.
3. The form asks for a surrender, if any, to be processed only as part of the exchange, not as a separate cash-out.
4. Any required signature guarantee or notarization is done.

Do not cash a check made out to you in the middle of this process. If one arrives, call both companies before doing anything.

A partial exchange, where only part of the old contract moves, is worth a hypothetical of its own. Say the same $120,000 contract is split and $60,000 is moved to a new annuity. The basis and gain are generally divided in proportion, so each half carries $45,000 of basis and $15,000 of gain, before any charges. The two contracts now run side by side, each with its own surrender clock. That can be useful for spreading risk across companies, but it doubles the paperwork and makes the rules on later withdrawals more important. Ask a tax professional before using it.

If the old company calls you

A retention call is normal. Treat it as information gathering, and ask what the company can offer, whether any improvement is guaranteed in the contract, whether it changes the surrender schedule, and whether it will put the offer in writing. A verbal promise is not a contract term.

Step 7: keep the old contract until the new one is in force

The old company will not release the money until it has a valid request, and some paperwork passes back and forth. The timing varies by company, and exchanges can take several weeks, so ask both firms for their expected timeline and do not assume it will be quick.

During the wait, do not cancel the old contract or take a withdrawal from it. A withdrawal before the exchange is taxed gains-first, which means the gain comes out before your basis, and withdrawn gain before age 59½ generally carries a 10 percent additional tax, subject to exceptions. Also confirm that the old contract's market value adjustment is figured on the date the money leaves, which can differ from the date you signed.

Step 8: confirm what arrived and look for the tax form

When the exchange completes, the new company sends a confirmation or contract statement. Check it against the original numbers:

• the amount received, which should equal the old value minus any surrender charge or MVA you were told to expect;
• the cost basis carried over, which should match the old contract's basis, not the amount that moved;
• the owner, annuitant and beneficiary, copied correctly;
• the surrender schedule and any bonus, as written in the contract;
• the rider terms.

Basis errors do happen. In the hypothetical above, a new statement showing $116,400 of value and $116,400 of basis would be wrong, because it would erase the gain. The expected record is $90,000 of basis and $26,400 of gain ($116,400 minus $90,000), assuming the old basis carried over untouched and the surrender charge reduced the gain. How a surrender charge is treated in an exchange has details a tax professional should review. If the new company's record differs from the old company's, ask both to reconcile it in writing now, because the mismatch will otherwise surface years later, when you take a withdrawal.

The tax form

The old company should report the exchange to the IRS and to you on Form 1099-R, using a distribution code that marks it as a non-taxable exchange. If your form shows a taxable amount or the wrong code, ask the old company to correct it before you file your return. Keep the old statements, the exchange paperwork and the new contract together. If the IRS asks later, you will need to show the basis.

Step 9: use the free-look period

After the new contract is delivered, you have a right to review it and, within the free-look period, cancel and get your money back. The length varies by state and sometimes by age and by whether the purchase is a replacement; the guide on free-look period explains the variation. With an exchange, cancelling the new contract can leave you without the old one, so ask the new company in advance what a free-look cancellation does after an exchange, whether the money goes back to the old company and what that does to the tax treatment.

Where exchanges go wrong

Five patterns appear again and again.

• Taking the check. A check payable to the owner turns the move into a surrender. The gain is taxable, and a 10 percent additional tax can apply if the owner is under 59½.
• Ignoring the old surrender charge. The new contract's brochure rarely mentions what you gave up to get there.
• Forgetting the rider. Income benefits built on a benefit base cannot be moved, and the new rider starts from scratch.
• Mismatched roles. Changing the owner or annuitant in the process can break the exchange.
• Believing a bonus is free. A premium bonus is often recaptured through a longer schedule or lower rates, and it rarely repays the charge on the old contract.

If you have been misled about any part of a sale, you can file a complaint with your state insurance department; the steps are in how to file a complaint against a life insurer, and the tax side of the contract is in how annuities are taxed.

Key takeaways

• A 1035 exchange defers tax only if the money moves directly between companies and the owner stays the same.
• Gather the old contract's value, basis, surrender charge, MVA, rider terms and death benefit before you look at any new product.
• Divide the cost of leaving by the yearly benefit of the new contract and compare the result with the new lock-up period.
• Basis and gain carry over; check the new statement and the Form 1099-R code for both.
• Do not cancel or withdraw from the old contract until the new one is issued, and use the free-look period with the exchange in mind.