Cashing in an annuity usually produces taxable income. Additionally, if you surrender your annuity before the contract term is up, there’s a surrender charge.

But you aren’t stuck for years if you have a low-paying annuity or even a type of annuity, such as a variable annuity, that no longer meets your needs. You can make a tax-free 1035 annuity exchange. You can trade in an entire annuity or part of it for a better annuity at a different insurance company.

A 1035 exchange lets you switch companies while continuing to defer taxes, ensuring that your annuity stays up-to-date with the latest advantages, benefits and best rates available.

It’s one of the few parts of the tax code that works in your favor. Accumulated interest earnings from your original policy remain tax-deferred until you withdraw the funds from your new annuity sometime in the future. In contrast, surrendering an annuity is a taxable event and you must recognize any gain as current income.

A full 1035 exchange most often involves exchanging one fixed-rate annuity at the end of its surrender term for a better-paying fixed annuity. You can often get a higher interest rate than the renewal rate offered by your current insurer.

And you can exchange among types of annuities. For instance, if you want to lower your risk profile, you can exchange a variable annuity for a fixed annuity that guarantees principal. It’s a simple process. The funds go directly from the current insurer to the new one.

Partial 1035 exchanges

Partial exchanges provide additional flexibility. Anyone unhappy with a current annuity that’s still subject to a surrender charge can usually take advantage of the penalty-free withdrawal provisions of their existing contract. Most annuities let you withdraw 10% annually without penalty. Instead of taking receipt of the penalty-free withdrawal amount, you can move it to a new annuity via a partial 1035 exchange.

Many fixed-rate annuity owners move their penalty-free amount annually from a lower-interest-rate product bought years ago to a higher-paying current annuity. Some are doing partial exchanges from variable and fixed-indexed annuities into fixed-rate multi-year guarantee annuities (MYGA).

Caution must be exercised when executing a partial 1035 exchange. There’s a special IRS rule when using non-qualified funds (money not in a retirement plan) in a partial exchange. If any withdrawals are made from either contract within 180 days of a partial exchange, the exchange is invalidated and becomes a taxable event.

Life insurance policy can be exchanged for an annuity

Many older people have paid-up cash-value life insurance policies that they no longer want or need. Section 1035 lets you exchange such a policy for an annuity tax-free.

You could use the cash value to buy any type of annuity. One good choice is a deferred income annuity, which will pay an individual or a couple a guaranteed lifetime income starting at a date the owner chooses.

The owner or owners of the life insurance policy and the new annuity must be identical.

All 1035 exchanges, whether full or partial, require serious thought. Only after careful examination of available alternatives can you decide if a 1035 exchange makes sense for your individual situation.

Annuity expert Ken Nuss is the founder and CEO of AnnuityAdvantage, a leading online provider of fixed-rate, fixed-indexed and immediate-income annuities. He launched the AnnuityAdvantage website in 1999 to help people looking for their best options in principal-protected annuities.