1035 Exchange Rules, The Like-Kind Annuity Swap, Time Limits, and Common Traps

Written & reviewed by Hans Goldstein, EA, Independent Licensed Insurance Producer · CA license 4273294 · NPN 20602398
Admitted to practice before the IRS
Last reviewed 2026-10-03

What §1035 actually allows

Section 1035 of the Internal Revenue Code permits the tax-free exchange of specific insurance contracts. The full list of permitted exchanges:

The key word is like-kind. The IRS considers annuities and life insurance to be tax-deferred insurance contracts. Mutual funds, ETFs, CDs, savings accounts, and money market funds are not insurance contracts, so you cannot 1035 into them.

Trying to "1035" an annuity into a brokerage account triggers a full surrender. The IRS treats the surrender as ordinary income on all gains above your basis (cost basis = total premiums paid). If you're under age 59½, add the 10% early withdrawal penalty on the gain.

The mechanics: trustee-to-trustee

A 1035 exchange must be a direct trustee-to-trustee transfer. You never receive a check made out to you. The receiving carrier sends a 1035 exchange form to the surrendering carrier. The funds move directly between the two companies.

Standard timeline:

1. Day 0: New application + 1035 exchange form signed at new carrier
2. Day 1-3: New carrier sends documents to old carrier
3. Day 7-14: Old carrier processes surrender; calculates surrender charge if applicable
4. Day 14-30: Wire transfer to new carrier; new contract issued and effective

What can go wrong:

• If the check is made out to you (not the carrier), the IRS may treat it as constructive receipt, converting the "exchange" into a taxable distribution + new purchase.
• Old carrier may withhold federal taxes if forms are not coded as 1035 exchange. Always confirm in writing that the surrendering carrier classifies the distribution code as "6" (1035 exchange) on Form 1099-R.
• Some carriers have anti-rebating or processing delays of 30-60 days. Build the surrender-charge schedule around this.

Surrender charges do NOT reset what you'd hope

This is the single biggest 1035 misunderstanding. The surrender charge schedule from the old contract is still enforced when you exchange.

If you bought an annuity in year 3 of a 10-year surrender schedule and exchange in year 6, the old carrier collects whatever surrender charge applies in year 6 (typically 4-6% of cash value). That charge comes out of the proceeds before they transfer.

Worse: the new contract starts its own surrender-charge clock at day zero. So you go from having 4 years of surrender remaining on a contract you understand into a brand-new 7- or 10-year surrender period on a contract you don't yet have experience with.

The 1035 should only happen if one of these is true:

• Old contract is out of surrender entirely (you'd pay zero charge to leave)
• New contract pays a surrender-charge bonus that covers the cost of leaving (e.g., a 6% premium bonus that exceeds the 4% surrender charge)
• The new contract's credited rate over the surrender period is so much higher that it overcomes the surrender charge cost
• You're moving for a structural reason (carrier downgrade, riders no longer fit your plan, lifetime income value)

The math on a surrender + 1035 needs to net positive after the charge. We model this for every client considering a 1035; the result is "don't bother" about 70% of the time.

The six-month rule and the partial 1035

Two technical IRS rules that catch buyers:

The six-month rule (Rev. Rul. 2002-75)

If you do a partial 1035 exchange (move some funds, leave some) and then take a distribution from either contract within 180 days, the IRS may aggregate the partial 1035 with the distribution and treat the full move as a taxable distribution.

Practical rule: after a partial 1035, take no withdrawals from either contract for 6 months. If you need income, structure the partial 1035 differently or wait the period.

Pre-TEFRA contracts (issued before August 14, 1982)

Old annuities have special tax treatment: withdrawals come out of basis first, then gain. New annuities are gain-out-first (last-in-first-out, or LIFO). A 1035 exchange wipes out pre-TEFRA status. If you have an annuity from before 1982 that you've never touched, talk to a tax pro before exchanging. You may be giving up a meaningful tax shield.

Loans on life insurance

If you 1035 a life policy with an outstanding loan into an annuity, the loan amount may be treated as boot (taxable). Pay off the loan first, then exchange.

Worked example: should I 1035 my old VA?

Scenario: Hans's client has a $400,000 variable annuity bought in 2018, 7-year surrender schedule (now in year 5 of 7, surrender charge = 3.5%). Mortality & expense charges = 1.40% per year. Subaccount management = 0.85%. Income rider = 1.00% per year. Total annual drag: 3.25%.

She's considering 1035 into a MYGA at 5.60% guaranteed for 7 years.

Cost of leaving: 3.5% surrender charge = $14,000 deducted from $400,000 = $386,000 transfers.

Cost of staying for the remaining 2 years of surrender: 3.25% × $400,000 × 2 = $26,000 in fees (assuming flat balance). Plus subaccount return assumption needed.

What she earns at the new MYGA: $386,000 × 5.60% × 7 = roughly $182,500 of guaranteed interest over the new 7-year term.

What she'd earn if she stayed 2 more years then surrendered: Assume subaccount returns 5% gross, net of 3.25% fees = 1.75% net. $400,000 × 1.75% × 2 = $14,140 net growth. Then she'd surrender penalty-free at year 7.

Decision: 1035 wins here, but only because the MYGA rate is 110 bps higher than her net VA return. If the VA's subaccount return assumption rises to 7-8% net, the calculation flips. Run the math for your specific contract. The right answer is contract-specific.

The riders question

The trickiest 1035 cases involve variable annuities with valuable income riders. The cash value of a VA might be $300,000, but the "income base" (the number the rider uses to compute lifetime income) might be $450,000, locked in during a high-water-mark year.

If you 1035 to a MYGA, you walk away from the $450,000 income base permanently. The new MYGA pays interest on the $300,000 cash value, not the $450,000 base.

Decision framework for VA-with-income-rider:

• If you plan to actually turn on the lifetime income within 1-3 years: usually keep the VA
• If you're under 60 and won't activate income for 10+ years: the high fees usually erode the rider benefit; consider 1035
• If the rider is in "step-up" mode and the market has been weak: keeping the VA preserves optionality on a future step-up

Always pull the carrier's specific rider documents before deciding. Generic advice is dangerous here.

Related reading

• Best MYGA rates: 2026
• Roth conversion vs MYGA bucket
• 4% rule vs annuity replacement
• MYGA loan vs surrender
• QCD rules for 2026

Want my independent take on whether this fits your situation?

I'm Hans Goldstein, an independent licensed insurance producer (NPN 20602398), appointed with multiple A-rated carriers. I run side-by-side comparisons against CDs, MYGAs, Treasuries, and MMFs every week for retirees and pre-retirees. Tell me what you're considering and I'll send back a written comparison.

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Disclosure

This article is general educational information, not personalized financial, tax, or legal advice. All rates, IRS limits, Social Security PIA factors, IRMAA brackets, FDIC/NCUA coverage, and state guaranty fund coverage figures are current as of the publication date and subject to change. IRMAA brackets and Roth/Traditional IRA limits cited reflect IRS guidance for 2026 and may be updated by the IRS or SSA; confirm current figures at irs.gov and ssa.gov before acting. Hans Goldstein is an independent licensed insurance producer (NPN 20602398) appointed with multiple A-rated annuity carriers; he does not sell bank CDs, money market funds, or Treasury securities and is not affiliated with any bank, brokerage, or government agency discussed. No compensation has been received from any third party in connection with this article. Bank CDs are FDIC-insured deposit products; credit union share certificates are NCUA-insured; money market funds are SEC-regulated investment products with no FDIC coverage; Treasuries are direct obligations of the U.S. government; MYGAs are insurance contracts backed by carrier balance sheets and state guaranty associations. These are different product categories with different protections, tax treatments, and trade-offs. Always confirm current rates and tax law with the issuer or a CPA before acting.