A 1954 Rule Called Section 1035 Lets You Trade a Bad Annuity for a Better One With No Tax Bill. The Agent Selling the New One Rarely Mentions the Surrender Charge on the Old One
A 72-year-old tax rule lets retirees swap annuities without triggering a federal income tax bill, and agents love to pitch it. What they tend to leave out could cost you more than the tax break saves.
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Consider a 67-year-old retiree who has a variable annuity she bought three years ago for $150,000. It’s now worth $200,000. The fees are high, the investment menu is stale, and an agent has a shiny replacement ready. She can move every dollar to the new contract without owing a cent of federal income tax on her growth.
Then she reads the fine print on the old contract: a $10,000 surrender charge, taken out on her way to the exit. The tax break is real. So is the toll booth, and the person recommending the switch gets paid when she drives through it.
Section 1035 Has Shielded Annuity Swaps for 72 Years
The rule is Section 1035 of the Internal Revenue Code, which became law on August 16, 1954. That makes it 72 years old. It says “no gain or loss shall be recognized” when you exchange an annuity contract for another annuity or for a qualified long-term care insurance contract. Life insurance can also be exchanged into an annuity, but it only works in that direction. The law gives no path from an annuity into life insurance.
The long-term care option came later, added in 2006. Your original cost basis carries into the new contract, so the tax waits until you take withdrawals.
Her $10,000 Toll Comes Before the Tax Break
Assume her contract uses the schedule the SEC uses in its investor guidance: a surrender charge that starts at 7% in the first year, declining by 1% each year. In year three, the charge is 5%.
| Item | Amount |
|---|---|
| Contract value | $200,000 |
| Surrender charge (5%) | $10,000 |
| Amount transferred | $190,000 |
| Cost basis carried over | $150,000 |
| Untaxed gain carried over | $40,000 |
| Tax avoided vs. cashing out (22% bracket) | $8,800 |
If she cashed out instead, that $40,000 gain would face the same income tax rates as her wages. If all of it fell in the 22% bracket, she’d owe $8,800. Section 1035 saves her that bill. The surrender charge still costs her $10,000.
Run the Bonus Pitch Through a Calculator
Agents often counter with a bonus. The SEC’s own example describes a new annuity that pays a 4% bonus credit and has a surrender charge period of eight years. On her balance, that bonus comes to $7,600, bringing her to $197,600. That still leaves her $2,400 short of what she paid to leave. The SEC also warns that a new surrender charge period generally begins when you exchange.
Suppose the new schedule also starts at 7%. Taking out her money out in year one would cost $13,832. She switched a 5% exit fee for a 7% one and reset an eight-year clock.
Assume the new contract costs 1% less per year than the old one. That saves about $1,900 a year, so it takes roughly 5.3 years just to earn back the surrender charge.
Patience costs less. Two more years drops her charge to 3%, or $6,000. After year seven, the charge is zero.
Regulators Track Serial Annuity Switching
Brokers selling variable annuities must follow FINRA Rule 2330, which requires them to consider whether the customer has had another deferred variable annuity exchange within the past 36 months. In a 2025 case, FINRA fined a former rep and suspended him for 12 months for recommending 10 unsuitable L-share annuity switches.
Consumer advocate Clark Howard puts it more bluntly. On his August 24, 2026 show, he said insurance salespeople “make their money off commissions and have too strong a financial incentive to put you in what’s better for them than for you.”
Four Rules That Keep a 1035 Exchange Tax-Free
- Never take possession of the money. The old insurance company should send the funds straight to the new one. If the check is made out to you, the exchange can become a taxable surrender.
- Keep the owner and annuitant the same. Changing who has the contract during the exchange can create tax or gift problems.
- Wait 180 days after a partial exchange. If you move only part of a contract, taking a distribution from either policy for 180 days can wipe out the tax-free treatment.
- Check your Form 1099-R. A completed exchange should show distribution code 6. If your Form 1099-R has a code 7, it means the insurance company reported it as a taxable distribution, and you’ll want that fixed before you file.
Before signing anything, ask the agent for the surrender schedules on both contracts, the commission on the new one, and the total annual fee on each. Then have a fee-only fiduciary who earns nothing from the switch check the math to make sure is a good option for you.
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Vilma Rios is a tax professional and tax content contributor with more than 15 years of experience in tax and accounting. She specializes in federal tax research, tax education, and translating complex tax rules into clear, practical information for individuals, families, and small-business owners.
Vilma is a Content Tax Contributor II with the National Association of Tax Professionals (NATP), where she contributes to tax education and professional content. She has also presented tax information through webinars, including Spanish-language tax education, and has appeared on Telemundo 47 discussing tax topics and helping viewers understand important tax-filing requirements.
Her experience also includes tax and accounting work, tax research, IRS-related matters, and public tax education. While in college, Vilma volunteered in an IRS-sponsored tax assistance program and was recognized for her community service by local and state officials.
Known as “Your Tax Geek,” Vilma is passionate about making taxes easier to understand and helping people navigate an increasingly complex tax system.
