When Swapping an Annuity Makes Sense, and When It Doesn't

If a client owns an annuity, especially one purchased years ago, it could cost more than it should. Maybe the fees are north of 2%, the investment options are limited, or the product just doesn't fit the way it once did. That's where the 1035 exchange enters the conversation, yet another aspect to a wealth planning process that goes well beyond picking stocks and bonds.

Named after Section 1035 of the Internal Revenue Code, a 1035 exchange allows a client to swap one annuity for another, or one life insurance policy for another, without triggering a taxable event. On paper, it sounds like a no-brainer. However, like most things in financial planning, the details matter. As a fee-only firm that has never sold insurance or commission-based products since our founding in 1965, we think we're in a unique position to partner with a trusted insurance resource and walk through the analysis objectively. We don't earn a commission if a client makes a switch, and we don't earn one if they stay put. Our only interest is whether the move genuinely improves their financial outcome.

Rather than surrendering an existing annuity, taking the cash, and purchasing a new one, which would create a taxable event on gains, a 1035 exchange transfers the contract directly from one insurance company to another. The cost basis carries over, the tax deferral remains intact, and no income is recognized at the time of the exchange.

• Fees: Fee reduction is the most common driver for making a change. Many annuities sold in the 1990s and 2000s carry total annual costs of 2.5% to 3.5% or more. Today, modern low-cost annuities from providers like Nationwide, Schwab, and others offer all-in costs well below 1%. Over a decade or more, that difference compounds significantly. In some cases, an annuity analysis can reveal the contract holder is paying for “features” of the annuity they no longer need and shouldn’t be paying for.
• Investment Options: Better investment options matter too. Older annuities often limit a client to a handful of proprietary subaccounts with mediocre track records. Newer products offer access to institutional-quality funds, index options, and potential for greater diversification.
• Surrender Charges: Avoiding surrender charges is another advantage. Many modern advisory annuities have no surrender period at all. If a client's current annuity has already passed its surrender window, the move can often be made with no exit cost.
• Consolidation: Simplification through consolidation can clarify the wealth plan. If a client has accumulated multiple annuity contracts over the years, perhaps sold at different times by different brokers, consolidating through 1035 exchanges can streamline their financial life and make the overall plan easier to manage.
• Tax Deferral Maintained: Perhaps most importantly, the tax deferral is preserved. If an annuity has significant embedded gains, cashing out means writing a check to the IRS. A 1035 exchange repositions the assets without incurring taxable income.

To illustrate how the numbers play out, consider a hypothetical example.

A couple in their early 60s, let's call them David and Linda, own a variable annuity worth $750,000. It was sold to them about twelve years ago by a broker who has since retired. The surrender period has long expired, and neither can recall the last time anyone reviewed the contract with them.

A closer look at the contract reveals a mortality and expense charge of 1.35%, an administrative fee of 0.15%, a guaranteed income rider fee of 1.10% (on the benefit base), and underlying subaccount expenses averaging about 0.85%. All in, they're paying roughly 3.45% per year, approximately $25,875 annually, quietly deducted from their account value.

Now, suppose the guaranteed income rider's benefit base hasn't grown meaningfully because the high fees have eaten into performance. David and Linda have no immediate plans to annuitize, and the rider's payout terms aren't competitive enough to justify the ongoing cost.

If they were to execute a 1035 exchange into a modern, low-cost advisory annuity with no surrender charges, a broad investment lineup, and a total all-in cost of approximately 0.50%, their annual expense would drop to roughly $3,750 per year.

The result: Annual savings of more than $22,000. The cost basis carries over, the tax deferral remains intact, and they gain access to a far better investment platform. Over the next ten years, assuming modest growth, that fee savings alone could add $250,000 or more back into their account.

The annuity wasn't necessarily a bad product when it was purchased, but the world has changed. Costs have come down dramatically, and many legacy contracts are simply no longer competitive.

Surrendering valuable legacy benefits is the biggest risk. Many older annuities, particularly those issued between 2005 and 2015, contain guaranteed income riders with terms that simply don't exist anymore. Guaranteed roll-up rates of 6% or 7%, generous payout percentages, and favorable mortality assumptions. Once a client exchanges out of that contract, those benefits are gone forever.

The critical question is always: "What is being given up, and can it be replaced?" If the answer is a deeply in-the-money income guarantee, the math may favor staying put—even with higher fees.

In addition, surrender charges on the existing contract may still apply. A 1035 exchange doesn't waive exit fees. If a client is still within a surrender period, charges of 3% to 7% may apply. Sometimes it makes sense to wait. Depending on the level of the remaining surrender charges, it could make sense to pay the charges when factoring in fee savings over the life of the new contract.

A new product isn't automatically a better product. A thorough comparison—not just of fees, but of features, flexibility, and how the product fits within the broader plan—is essential. This is why we always recommend working with a trusted specialist in the insurance & annuity business for which we can coordinate a conversation and pull together all the pertinent facts.

A 1035 exchange for annuities is often described as "tax-free," but tax-deferred is more accurate.

The cost basis carries over, it does not reset. If a client invested $200,000 into an annuity now worth $350,000, the $150,000 of embedded gain follows them to the new contract. A 1035 exchange changes the vehicle, not the eventual tax bill. This is critical because annuity gains are taxed as ordinary income, not capital gains. Unlike a brokerage account where long-term gains might be taxed at 15% or 20%, annuity withdrawals above basis are taxed at the client's ordinary income tax rate—potentially 24% to 37% at the federal level.

In addition, the IRS applies a "last in, first out" rule. Withdrawals are treated as gains first, basis second. Every dollar comes out taxable until the gain is exhausted, making early or partial withdrawals more tax-costly than expected.

The 3.8% Net Investment Income Tax may also apply. For clients with modified adjusted gross income above $250,000 (married filing jointly), annuity gains are subject to the additional Medicare surtax, effectively pushing the top marginal rate above 40%.

Partial 1035 exchanges require careful handling. The 180-day rule is critical; if a withdrawal is taken from either contract within 180 days of a partial exchange, the IRS may recharacterize the entire transaction as a taxable distribution.

If the annuity is inside a qualified account, a 1035 exchange doesn't apply. Annuities held inside an IRA or 401(k) are already tax-deferred by virtue of the account structure. The 1035 rules apply only to non-qualified contracts.

The bottom line on taxes: a 1035 exchange is a deferral strategy, not an avoidance strategy. It buys time to let money compound in a lower-cost structure, plan withdrawals in lower-income years, and coordinate distributions with the rest of the tax picture. The tax bill doesn't go away—it is simply deferred.

Annuities can be very complicated, and we think it’s critical to work with a trusted resource who specializes in evaluating these products as part of the broader wealth strategy. We consulted with Ward & Connoly, an insurance broker in the Columbus area, to gather additional perspective on this topic. Adam Lemke CFP® summed it up this way:

“Annuities are fundamentally an insurance contract. The reason you originally purchased the insurance may no longer be a relevant risk that needs addressed. By completing a review of the annuity and looking at it through the lens of the financial plan, often the annuity no longer makes sense and a change to the insurance plan is necessary.”

A 1035 exchange can be a powerful tool for the right situation. Used wisely, it can reduce costs, improve flexibility, and modernize a financial plan without creating a tax bill. Used carelessly, it has the potential to destroy valuable guarantees and create unnecessary complexity. If a client owns an annuity and isn't sure whether it still belongs in their plan, we're happy to take an objective look. No product pitch and no commissions to earn, just objective advice.