Stuck in an Annuity You Regret? The 1 Tax Rule That Lets You Swap It Without an IRS Bill

Plenty of retirees sign an annuity contract and later regret it. The fees run higher than expected, the rate looks low, or the income rider no longer fits the plan. Cashing out can trigger a tax bill on years of deferred gains. The Internal Revenue Code offers another path, often called a ten thirty-five exchange, that lets an owner move from one annuity into another without recognizing gain on the swap.

Rates are one reason the question is coming up. The 10-year Treasury yield stood at 4.90% on November 4, 2026, down from 5.28% on October 7. People who bought contracts in lower-rate years often compare their terms with newer products. The tax rule can make a switch possible, but it is only one piece of the decision.

What Section 1035 Lets You Swap

Under 26 U.S.C. § 1035(a)(3), no gain or loss is recognized on the exchange of “an annuity contract for an annuity contract or for a qualified long-term care insurance contract.” A life insurance policy can also move into an annuity under § 1035(a)(1). The reverse direction is taxable: Treasury regulations say the section does not apply when an annuity is exchanged for a life insurance contract, and in that case “any gain or loss shall be recognized.”

The same regulation, 26 CFR 1.1035-1, limits annuity-for-annuity exchanges to cases where the same person or persons are the obligee or obligees under both the new contract and the original. If you get cash or other property along with the new contract, the regulation sends you to section 1031(b) and (c), which means that extra value can be taxed.

Why the Money Has to Move Directly Between Insurers

The exchange works when the old insurance company sends the contract value straight to the new insurance company. If you surrender the contract and deposit the check yourself, that counts as a withdrawal. Amounts taken out before the annuity starting date are included in gross income “to the extent allocable to income on the contract” under § 72(e)(2)(B)(i). Younger owners can also face § 72(q)(1), which raises tax by 10% of the taxable portion unless an exception applies.

IRS Publication 575 says an exchange with a different company shows up on Form 1099-R with code “6” in box 7, and “You need not report this on your tax return.” The publication also covers a narrow election under Rev. Proc. 92-44 for certain cases where cash came out of the old contract and was reinvested. That path requires statements to the new issuer and attachments to a timely filed return.

Your Cost Basis Carries Over

Section 1035(d)(2) points to section 1031(d) for basis, so what you put into the old contract becomes your basis in the new one. The deferred gain remains until you take a later withdrawal or annuitize. Publication 575 adds that the new contract’s purchase date is the date you purchased the annuity you exchanged, which matters for the immediate-annuity exception to the early-distribution tax.

Hypothetical example: A retired teacher paid premiums into a deferred annuity years ago, and the contract is now worth well more than she paid. If she exchanges it, her original premiums become her basis in the new contract and the growth stays tax-deferred. If she cashes out, that growth is taxable in the year she surrenders.

Partial Exchanges

You can move part of a contract instead of all of it. IRS Revenue Ruling 2003-76 treats an exchange of a portion of an annuity contract into a new annuity contract as tax-free under section 1035. Basis gets split between the two contracts, and withdrawals soon after a partial exchange can draw IRS attention. Check the timing with a tax professional before you take money out.

Costs That Survive the Swap

The exchange avoids income tax on the swap. It does not waive surrender charges on the old contract. If you are still in the surrender period, the old insurance company takes its charge before the money moves. The new contract may also start a fresh surrender period, which ties up your money for more years. Questions to ask before signing:

• What is the current surrender charge on my contract, and when does it drop to zero?
• What does the new contract charge each year in total, including base fees, rider fees and any fund expenses?
• How long is the new surrender schedule, and how much can I take free each year?
• Which riders or death benefits do I lose? An enhanced death benefit or an income rider with a built-up benefit base generally stays with the old insurance company.
• What supports the guarantee? Guaranteed income or minimum rates depend on the issuing insurer’s claims-paying ability, and state guaranty association limits vary by state.
• How is the person recommending the swap paid? A replacement sale usually earns a new commission.

Who Benefits From an Exchange and Who Should Wait

An exchange tends to fit owners whose surrender period has ended or is nearly over, whose current contract has high ongoing fees and no valuable rider, and who have the replacement’s costs, terms and surrender schedule in writing. It can also fit someone who wants to move from a contract built for growth into one built for income, or into a qualified long-term care insurance contract.

Waiting makes more sense if you still face a high surrender charge, if the new product’s main selling point is a bonus that restarts the surrender period, or if you would give up an income or death benefit rider worth more than the new contract’s features. In those cases, keeping the contract until the surrender schedule runs out may cost less than switching now.

Keep an eye on rates as you compare offers. The 10-year yield’s drop from 5.28% to 4.90% over the past month shows how quickly the terms of new contracts can change. Ask for the replacement’s surrender schedule and a list of every fee and rider charge in writing, along with a side-by-side comparison against your current contract, before you sign transfer paperwork.

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