Tax-free annuity-to-annuity transfer
Quick Definition: A 1035 exchange allows you to transfer funds from one annuity to another without triggering income taxes on gains. Named after IRS code Section 1035, it enables you to switch products while maintaining tax deferral. However, surrender charges from the old annuity may still apply.
A 1035 exchange is a direct transfer between insurance companies. You never touch the money—it goes directly from Company A to Company B, preserving tax-deferred status.
Current annuity: $180,000 account value (original premium $150,000, gains $30,000)
Issue: High fees (2% annually), poor performance, 2 years left in surrender period
Option 1: Cash out
→ Pay income tax on $30,000 gain = ~$7,500 (25% bracket)
→ Pay 3% surrender charge = $5,400
→ Net received: $167,100
Option 2: 1035 Exchange to better FIA
→ No income tax (deferred)
→ Still pay 3% surrender charge = $5,400
→ New annuity receives: $174,600
→ Savings: $7,500 in taxes avoided
Result: Save $7,500 by using 1035 exchange instead of cashing out.
Allowed exchanges:
NOT allowed:
1035 exchanges avoid income tax but NOT surrender charges. If your old annuity has a 5% surrender charge, you still pay it even though you're doing a 1035.
Strategy: Wait until surrender period ends, then do 1035 exchange to avoid both taxes and surrender charges.
Good reasons:
Bad reasons (red flags):
Before doing a 1035 exchange, calculate:
1. Surrender charge on old annuity: How much do you lose?
2. New surrender period: How long are you locked in again?
3. Fee savings: How much lower are annual costs?
4. Better terms: Higher caps? Better participation?
If new product has 1% lower fees, you save $2,000/year on $200K. Surrender charge of $6,000 breaks even in 3 years. If you're staying for 10+ years, exchange makes sense.
⚠️ Warning: Some advisors push 1035 exchanges to generate new commissions. Make sure the new product genuinely benefits you, not just the advisor. Get independent analysis before exchanging.
Step 1: Complete 1035 exchange forms with new insurance company
Step 2: New company requests funds from old company
Step 3: Old company processes request (2-6 weeks typical)
Step 4: Funds transfer directly between companies
Step 5: New annuity is established with full value
Never take possession of funds yourself—this disqualifies the tax-free treatment.
1. Stay put: If surrender period is almost over and product is adequate, just wait
2. Partial 1035: Exchange portion of annuity, keep rest in original
3. Free withdrawal + 1035: Take annual 10% free withdrawal, then 1035 exchange the rest
Insurance companies report 1035 exchanges to IRS on Form 1099-R with special code indicating tax-free exchange. You must report it on your tax return even though it's not taxable.
1035 exchanges let you switch annuities without paying taxes on gains—but surrender charges still apply. Use this strategy when new product offers meaningfully better terms that justify costs. Be wary of advisors pushing exchanges primarily to earn commissions. Always get independent analysis of whether the exchange truly benefits you.