1035 Exchange
A 1035 exchange is a tax-free exchange of one annuity contract for another, authorized by Section 1035 of the Internal Revenue Code. The mechanism allows a consumer to move from one carrier to another, or from one annuity type to another (e.g., from a MYGA to a SPIA), without recognizing gain on the existing contract's built-up earnings. The exchange must be a direct contract-to-contract transfer; the consumer cannot receive the proceeds and then deposit them into a new contract.
A 62-year-old owns a deferred variable annuity purchased 12 years ago with $150,000 in non-qualified money. The contract has grown to $230,000. The consumer is unhappy with the M&E charges and wants to move to a fixed annuity. She initiates a 1035 exchange: her current carrier sends the $230,000 directly to the new MYGA carrier, who issues a new contract in her name. No tax is owed on the $80,000 of accumulated gain — the cost basis ($150,000) transfers to the new contract, and tax will be owed only when she eventually withdraws or annuitizes the funds.
Why it matters
The 1035 exchange is one of the most useful planning tools in the annuity world. It allows consumers to upgrade contracts (from older, more expensive variable annuities to newer, lower-cost ones), to consolidate multiple smaller contracts, or to convert accumulation contracts into income contracts — all without triggering an immediate tax bill. Without 1035, every contract change would create a taxable event on the accumulated gains.
How to evaluate
Before initiating a 1035 exchange, check (1) whether the existing contract has remaining surrender charges (they apply to the exchange amount and are paid out of the transferred value), (2) whether the existing contract has valuable rider benefits being given up, and (3) whether the new contract has a fresh surrender schedule starting at year zero. A 1035 exchange that restarts a 10-year surrender period to capture a modest rate improvement is often not worth it.
In the contract
The exchange process is administrative — there are 1035 exchange request forms at both carriers. The consumer's cost basis (the original premium plus any 1035-rolled-in basis) is tracked by each carrier and reported on Form 1099-R when distributions begin.
Related terms
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