A 1035 exchange allows owners to exchange outdated contracts for more current or efficient contracts, while retaining the original contract's tax basis and deferring recognition of any gain for federal income tax purposes. Generally, the surrender of an existing annuity contract is taxable, meaning the owner must recognize any gain on the "old" contract as current income. However, under IRC Section 1035, when one annuity contract is 1035 exchanged for another, the transfer is considered non-taxable, provided certain requirements are met.

Non-Qualified Annuities

Money can be transferred from one non-qualified annuity to another annuity income tax-free using a 1035 Exchange. The owner may incur withdrawal charges from the current annuity, and some insurance companies penalize owners for early withdrawals. Federal tax form 1035 should be used, and any loans outstanding loans should be repaid before the exchange.

Qualified Annuities

1035 exchanges do not apply to qualified annuities. If an investor wants to rollover a qualified IRA annuity, a check can be requested from the current custodian, payable to the owner personally. The owner then has 60 days to put the money from the old IRA into a new IRA. In that case, the IRA remains intact and no federal income tax or tax penalties will be owed on the money. The IRS allows IRA rollovers once every 12 months.

Direct Transfer

If the investor wants to transfer money directly from one qualified IRA custodian to another, a "direct transfer" avoids the risk of owing any federal income tax or tax penalties. Unlike a "rollover," which can only be completed once every 12 months, the IRS does not limit the number of Direct Transfers.

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