Can You Do a 1035 Exchange on an Inherited Annuity?

A 1035 exchange is a provision in the tax code that permits the direct transfer of funds from one insurance contract to another without triggering an immediate tax liability. This mechanism allows policyholders to move to a different product that may offer better features, lower fees, or different investment options, all while maintaining the tax-deferred status of their accumulated gains. An inherited annuity is a contract received by a beneficiary following the death of the original owner.

Beneficiaries with an inherited annuity might wonder if they can use a 1035 exchange to move into a new annuity that better suits their financial objectives. The rules governing such a transaction are distinct and depend on the beneficiary’s relationship to the deceased and strict adherence to procedural guidelines established by the Internal Revenue Service (IRS).

Eligibility for the Exchange

Historically, the ability for a non-spouse beneficiary to execute a 1035 exchange on an inherited annuity was limited. The prevailing interpretation was that since the original owner was deceased, a key party to the contract was absent, complicating the exchange process. This often left non-spouse beneficiaries with the original annuity, regardless of whether its features aligned with their financial needs, such as having high fees or limited investment choices.

IRS Revenue Ruling 2007-24 provided a clear path for non-spouse beneficiaries. This guidance affirmed that a non-spouse beneficiary could perform a 1035 exchange under specific conditions. The exchange must be a direct transfer from one inherited annuity to another new annuity contract. This “like-for-like” requirement means the funds cannot be moved into a different type of product.

The ruling also established a requirement for titling the new contract. The new annuity must be explicitly registered as an inherited annuity to maintain its tax-deferred status and carry over the original distribution rules. This ensures the continuity of the inherited nature of the asset and prevents it from being treated as a new annuity owned directly by the beneficiary, which would have different tax implications.

Spousal beneficiaries have more flexibility. A surviving spouse can choose to treat the inherited annuity as their own, a process called spousal continuation, which allows them to become the new owner. This process allows them to defer distributions, name their own beneficiaries, and potentially reset the contract’s features. While they can also use a 1035 exchange, the option to assume ownership provides a different strategic path.

Required Information and Documentation

Information from the Original Annuity

Before initiating an exchange, the beneficiary must gather key data from the original annuity contract. This includes the full contract number, the legal name of the deceased owner, and their date of death. It is also necessary to obtain the contract’s cost basis (the total amount of after-tax premiums paid) and its current market value from the most recent statement.

Beneficiary Information

The beneficiary must also provide their own personal information for the new annuity application. This includes their full legal name, current residential address, and Social Security Number or Taxpayer Identification Number (TIN). The new insurance company will also require the beneficiary’s date of birth.

Required Documents

Several formal documents are needed to process the exchange. A certified copy of the original owner’s death certificate is mandatory to prove the beneficiary’s claim. The beneficiary will also need to complete the original annuity company’s claim forms and the new annuity company’s application forms. These forms are available from the respective insurance companies.

Completing the New Application

When filling out the application for the new annuity, the application will have a section to indicate the source of funds, where the beneficiary must clearly state that it is a 1035 exchange. It is also here that the precise titling, such as “Deceased’s Name for the benefit of Beneficiary’s Name,” must be entered correctly. This step is fundamental to ensuring the transaction is processed as a non-taxable event and the new contract correctly reflects its inherited status.

The Exchange Process

The first step is to submit the complete application package to the new insurance company. This package includes the new annuity application, the signed claim forms for the old annuity, and the certified death certificate.

The core of the 1035 exchange is the direct, trustee-to-trustee transfer of funds. The new insurance company will contact the original annuity company to request the direct movement of the contract’s value. The beneficiary must not take personal receipt of the money at any point during this process, as the transaction would be disqualified as a 1035 exchange and become a taxable event.

After the application is submitted, the beneficiary should receive a confirmation of receipt from the new insurance company. The transfer process takes between two and six weeks to complete. Once the funds have been successfully moved and the new inherited annuity is funded, the beneficiary will receive a final confirmation and a new contract.

Post-Exchange Tax and Distribution Rules

A key feature of a 1035 exchange for an inherited annuity is the carryover of the original contract’s tax attributes. The cost basis, which represents the after-tax contributions made by the original owner, transfers directly to the new annuity, and the tax-deferred growth also moves over. The exchange does not trigger a “step-up” in basis, meaning the untaxed gains remain untaxed until they are withdrawn.

The distribution requirements that applied to the original inherited annuity remain in full force for the new annuity. The 1035 exchange does not reset the clock on these mandated withdrawal schedules. For instance, if a non-spouse beneficiary was subject to the 10-year rule from the SECURE Act, that 10-year period continues uninterrupted. The exchange changes the investment vehicle, not the underlying distribution timeline.

For the tax year in which the exchange occurs, the beneficiary will receive a Form 1099-R from the original annuity company. This form will report the gross distribution amount, but Box 2a, the taxable amount, should show a value of zero. Box 7 of the form should contain the distribution code ‘6’ for a tax-free exchange under Section 1035. Subsequent withdrawals from the new annuity will be reported on a new 1099-R and will be taxed as ordinary income on the gains.