How a 1035 exchange works for annuities

If you own an annuity and have thought about switching to a different contract or insurer, you may have heard the term "1035 exchange." It refers to a section of the Internal Revenue Code that lets you move one annuity contract to another without triggering immediate income taxes on the accumulated gains. For Cary and Triangle-area retirees living on fixed income, understanding how this process works (and what it does not fix) can help you ask better questions before making any changes.

What a 1035 exchange actually is

Section 1035 of the Internal Revenue Code allows a direct, tax-deferred exchange of one annuity contract for another annuity contract. The money moves from the old insurance company to the new one without passing through your hands. You do not receive a check. There is no taxable event at the time of the exchange, as long as the IRS rules are followed.

Three conditions have to be met:

• The owner and annuitant on the new contract must be the same as on the old contract.
• The exchange must be direct, meaning the old insurer sends the funds to the new insurer, not to you.
• The contracts must be "like-kind." For annuity owners, that means annuity for annuity. (You can also exchange certain life insurance policies for annuities under Section 1035, but annuity-for-annuity is the most common scenario for readers here.)

This is not the same thing as a rollover from an IRA or 401(k). Those are governed by different sections of the tax code. A 1035 exchange applies to non-qualified annuity contracts, meaning annuities purchased with after-tax dollars outside of a retirement plan. If your annuity sits inside an IRA or employer plan, the transfer rules work differently, and you would generally use a direct trustee-to-trustee transfer or plan rollover instead.

Which annuity contracts qualify

The 1035 rules apply primarily to non-qualified annuity contracts. Here is what that means in practice:

• You bought the annuity with money that was already taxed. This is the most common setup for non-qualified annuities sold outside of retirement plans.
• Both the old and new contract must name the same owner and annuitant. Changing ownership as part of the exchange can cause problems with tax deferral.
• Partial exchanges are allowed. You can transfer part of your annuity's value to a new contract while keeping the rest in the original one, though this involves a specific IRS safe harbor rule covered below.

For annuities inside qualified retirement plans (IRAs, 401(k)s, 403(b)s), the transfer is typically handled as a plan rollover, not a 1035 exchange. Tax deferral still applies in those cases, but the paperwork and rules are different.

How the exchange process works

The actual mechanics vary by insurance company, but here is the general sequence most exchanges follow.

Review your current contract first. Get a recent statement and look at the surrender charge schedule, the cash value, the cost basis (what you paid in minus any prior withdrawals), and any living or death benefit riders. This information tells you what the exchange would actually look like financially, and it is what the new insurer will need to process the transfer.

Apply for the new annuity with a 1035 exchange request. When you apply, you fill out a 1035 exchange form that authorizes the new insurer to request the funds from the old company directly. You do not handle the money yourself.

The insurers coordinate the transfer. The new insurance company contacts the old one and arranges the direct transfer. This usually involves paperwork between the two carriers. The process commonly takes several weeks, but the exact timeline depends on the insurers involved.

The old contract is terminated or reduced. Once the funds transfer, the old annuity contract ends (or is reduced, in the case of a partial exchange). The new contract begins with the transferred value and its own terms going forward.

One detail worth noting: the surrender charges on the old contract do not disappear. If your old annuity has a surrender fee, it is deducted from the amount that moves to the new contract. The exchange avoids taxes, but it does not avoid contract-level fees.

Tax treatment at the federal level and in North Carolina

At the federal level, a properly executed 1035 exchange is not a taxable event. The gains in your old annuity carry over to the new contract on a tax-deferred basis. Your cost basis (the amount you originally paid in, minus any prior taxable withdrawals) transfers to the new annuity. The IRS requires the old insurer to report the exchange on a 1099-R using Code 6, which identifies it as a tax-free 1035 exchange rather than a taxable distribution.

You pay taxes later, when you withdraw money from the new annuity. At that point, the earnings portion of each withdrawal is taxed as ordinary income. The IRS uses a "last in, first out" method for non-qualified annuities, meaning withdrawals are treated as coming from earnings first, not your original investment.

In North Carolina, the state follows the federal treatment of the exchange itself. There is no separate state tax triggered by the transfer. However, when you eventually take money out of the annuity, those earnings are taxed as ordinary income on your North Carolina return. For 2026, North Carolina's individual income tax rate is a flat 3.99%. This applies to annuity income the same way it applies to wages or interest income. For more details see our guide on how annuities are taxed in North Carolina.

One more thing: if you are under age 59 and a half when you take a future withdrawal (not the exchange itself, but later distributions from the new contract), the IRS may also assess a 10% early withdrawal penalty on the taxable earnings, in addition to ordinary income tax. There are some exceptions to that penalty, but they depend on your specific situation.

Partial exchanges and the 180-day safe harbor

Not everyone wants to move the entire annuity. The IRS allows partial 1035 exchanges, where you transfer a portion of your annuity's cash value to a new contract and keep the rest in the original one. IRS Revenue Ruling 2003-76 confirmed this is permitted.

With a partial exchange, the cost basis is allocated proportionally between the old and new contracts. If you transfer 40% of the cash value, roughly 40% of your basis moves to the new contract.

There is an important condition. IRS Revenue Procedure 2011-38 established a safe harbor for these partial exchanges: to make sure the transfer is treated as tax-deferred, you should not take any non-annuity distributions from either the old or new contract for at least 180 days after the exchange. The one exception is for amounts received as long-term annuity payments (payments expected to last 10 years or more).

If you take a withdrawal from either contract within that 180-day window, the IRS could recharacterize the exchange as a taxable event. So if you think you might need cash from the annuity soon, a partial exchange may not be the right move without careful planning.

Costs and trade-offs to consider

A 1035 exchange does not mean the transfer is free. Several costs can reduce the value that moves to the new contract, and some trade-offs are easy to overlook.

Surrender charges on the old contract are the most common surprise. Many annuity contracts have a surrender charge schedule that can last several years from the date of purchase, although the exact length varies by contract. If you are still in that period, the old insurer will deduct the surrender fee from the amount transferred. A 1035 exchange does not waive surrender charges. See our guide on how annuity surrender charges work for more on what this can mean. This reduction in transferred value is one reason to run the numbers on your specific contract before proceeding.

The new contract comes with its own surrender period. You are starting the clock over. If you might need access to that money in the next few years, the new surrender schedule matters just as much as the old one.

Riders and features do not transfer automatically. Your old annuity may have income riders, death benefit enhancements, or other features that do not carry over to the new contract. The new contract may or may not offer comparable features, and the costs may differ. This is worth a side-by-side comparison before you sign anything.

The financial strength of the new insurance company is another factor. Annuity guarantees, including income payments and death benefits, depend on the issuing company's ability to pay claims years or decades from now. Moving to a new insurer means trusting a different company with those guarantees.

Interest rate and crediting terms may also change. If you are exchanging a fixed annuity or a fixed indexed annuity, the new contract's rates, caps, participation rates, or spreads will be whatever the new contract offers, not what you had before.

A useful comparison to keep in mind: the alternative to a 1035 exchange is often either keeping the existing contract as-is or surrendering the annuity entirely, paying taxes on the gains, and buying a new one with the after-tax proceeds. That second option typically costs more in taxes upfront, which is why the 1035 exchange exists as a tool. But the exchange is not automatically better than keeping what you have. The answer depends on your contract terms, your tax situation, and what you are trying to accomplish.

What to verify before starting

Before you initiate a 1035 exchange, it helps to gather certain information and check a few things. Here is a practical list:

• A current statement from your existing annuity, including cash value, surrender value, and cost basis.
• The surrender charge schedule on the old contract. How much would be deducted if you transferred today?
• Confirmation that the owner and annuitant on the old and new contracts are identical.
• The full terms of the new contract: surrender schedule, fees, rider costs, death benefit provisions, and interest crediting method.
• The financial strength rating of the new insurance company (from agencies like AM Best, S&P, or Moody's).
• Whether the exchange qualifies as a replacement under North Carolina Department of Insurance rules. When an annuity is being replaced (not just purchased as a brand-new policy), the new insurer must provide a replacement disclosure. The policyowner typically gets a 30-day free-look period after receiving the new contract. This gives you time to review the terms and cancel if something does not look right.

If your annuity is inside a qualified retirement plan, verify whether a 1035 exchange even applies. In most cases it does not. You would use a plan-to-plan transfer or direct rollover instead. Our page on what to check before signing an annuity contract offers additional steps that apply here too.

Common misconceptions

Several assumptions about 1035 exchanges come up regularly, and they are worth correcting before you move forward.

Some people hear "1035" and assume it means no cost at all. It means no immediate tax cost. It does not eliminate surrender charges, new contract fees, or the trade-offs of changing contract terms.

Others think cashing out the old annuity and buying a new one is basically the same thing. It is not. If you surrender the annuity and receive cash, the IRS treats the earnings as taxable income in that year. A 1035 exchange avoids that by keeping the transfer direct between insurers.

Partial exchanges come with their own misconception: that you can take money out of either contract right away. You can do a partial exchange, but the 180-day safe harbor matters. Take a non-annuity distribution too soon and the tax benefit can fall apart.

And some people expect the new contract to have the same features as the old one. Annuity contracts vary widely. Riders, fees, surrender schedules, and crediting methods are all contract-specific. Read the new contract before signing.

Questions to ask a licensed professional

Because annuity contracts, tax situations, and financial needs are all personal, a 1035 exchange is not something to figure out alone. Here are questions worth asking a licensed insurance agent or financial professional who is familiar with your situation:

• What are the surrender charges on my current contract, and how much would I lose by transferring now?
• How does the new contract's surrender schedule compare to what I have?
• What happens to my existing riders and death benefit provisions?
• Is the new insurance company financially strong enough to back my guarantees over the long term?
• How will the exchange be reported on my taxes, and what is my cost basis in the new contract?
• Does a partial exchange make sense for me, and can I realistically comply with the 180-day safe harbor?
• Am I better off keeping the contract I have?

North Carolina residents can verify that an insurance agent is properly licensed through the North Carolina Department of Insurance. The NC DOI Consumer Services Division handles licensing checks and consumer complaints. The NC Life and Health Insurance Guaranty Association provides limited protection for annuity contracts issued by licensed insurers that become insolvent, though that protection has caps and is not a substitute for choosing a financially sound carrier.

If you have a general question about annuity exchanges or want to understand how these rules might apply to your situation, you can use our Ask a Question page. For a broader look at how annuities work, our annuities guide covers related topics like surrender charges, taxes, and what to check before signing a contract.