To report a 1035 exchange on Form 1040, enter the gross distribution from Box 1 of your Form 1099-R on Line 5a and enter $0 on Line 5b, provided your 1099-R shows distribution Code 6 in Box 7 and $0 in Box 2a. That pairing tells the IRS the transfer happened and that none of it is taxable. Everything else about getting this right on your return flows from verifying the 1099-R before you file and keeping documentation that supports the zero.
Verify Your 1099-R Before You File
The surrendering insurance carrier issues a Form 1099-R after the exchange closes, and that document drives your reporting.1Internal Revenue Service. 2025 Form 1099-R – Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc. For a properly executed Section 1035 exchange, the boxes should read as follows:
- Box 1, Gross Distribution: the total contract value transferred to the new carrier.
- Box 2a, Taxable Amount: $0. IRS instructions specifically direct issuers to enter zero for a nontaxable Section 1035 exchange.
- Box 5, Employee Contributions: the premiums you paid into the old contract (your cost basis).
- Box 7, Distribution Code: Code 6, the code that identifies a Section 1035 exchange of insurance contracts.2Internal Revenue Service. 2025 Instructions for Forms 1099-R and 5498
Code 6 is the only code that signals a 1035 exchange. Code G looks similar in some tax-prep menus but applies to direct rollovers from qualified retirement plans like 401(k)s, which is a different transaction. If your 1099-R shows Code 7 (normal distribution), Code 1 (early distribution), or anything other than 6 for a transaction meant to be a 1035 exchange, call the issuing carrier and request a corrected form before filing. Submitting a return with the wrong code creates a mismatch inside the IRS’s automated system, and the notice that follows will propose tax on the full Box 1 amount.
Where the Numbers Go on Form 1040
The exchange is reported on the pension and annuity lines of Form 1040, Lines 5a and 5b.3Internal Revenue Service. 1040 (2025) Instructions
- Line 5a: enter the full amount from Box 1 of the 1099-R. This acknowledges the transaction on the return.
- Line 5b: enter $0. If Box 2a on the 1099-R is blank rather than showing zero, still enter $0 on Line 5b.
A large figure on Line 5a paired with zero on Line 5b is one of the more common triggers for a CP2000 notice proposing additional tax. That notice is computer-generated rather than an audit, but responding requires the exchange documentation, which is much easier to pull together at filing than two years later.
Many tax professionals write “1035 EXCHANGE” next to Line 5b to head off that inquiry. The Form 1040 instructions do not explicitly require the annotation, but it is a low-effort step. Some practitioners also attach a brief statement identifying the old and new carriers, both contract numbers, the gross amount, and the transfer date. That extra paper is worth the effort for paper-filed returns or when the exchange involved multiple contracts.
When Part of the Exchange Is Taxable
A 1035 exchange is fully tax-free only when you receive nothing but the new contract. If cash, a check, or other property comes to you alongside the new contract, that extra amount is called boot. Section 1035(d) cross-references Section 1031(b), which requires you to recognize gain up to the amount of boot received, no more.4Office of the Law Revision Counsel. 26 USC 1031 – Exchange of Real Property Held for Productive Use or Investment
An example makes this concrete. If the old contract had $30,000 in gain and you received $5,000 in cash alongside the new contract, you recognize $5,000 of ordinary income, the lesser of the gain and the boot. If the boot exceeded the gain, the tax stops at the gain.
The carrier should reflect the taxable boot in Box 2a of the 1099-R. On Form 1040, Line 5a still carries the full Box 1 gross distribution, and Line 5b carries the taxable portion from Box 2a. A short statement explaining the partial taxability reduces the chance of a follow-up notice.
Partial 1035 Exchanges
A partial 1035 exchange moves only a portion of one annuity contract’s cash surrender value into a new annuity contract. The IRS approved this treatment in Revenue Procedure 2011-38, subject to a condition that reaches beyond filing day: no withdrawal from either contract within 180 days of the transfer, other than annuity payments spread over 10 or more years or over one or more lives.5Internal Revenue Service. Revenue Procedure 2011-38
Reporting on Form 1040 works the same as a full exchange. The carrier issues a 1099-R for the transferred portion with Code 6 and $0 in Box 2a, and you place the gross amount on Line 5a with $0 on Line 5b. Take any amount from either contract inside the 180-day window, though, and the IRS will recharacterize the transfer based on its substance. In most cases, that means treating it as a taxable partial surrender followed by a new contract purchase, and the tax-free reporting you already filed will need to be amended. Put the 180-day date on your calendar the day the transfer settles.
When the Exchange Fails
An exchange that does not meet Section 1035’s requirements is treated as a full surrender of the old contract. The gain above your cost basis becomes ordinary income in the year the distribution occurred. Situations that cause this include the wrong contract types (an annuity cannot be exchanged for a life insurance policy, for example), different owners on the old and new contracts, the taxpayer taking possession of the funds even briefly, and violation of the 180-day rule on a partial exchange.6Internal Revenue Service. Notice 2003-51 – Taxation of Certain Tax-Free Exchanges of Annuity Contracts7Internal Revenue Service. Revenue Ruling 2003-76
The 1099-R will carry a distribution code other than 6, typically Code 7 for a normal distribution or Code 1 if you are under 59½. Box 2a will show the taxable gain. On Form 1040, the Box 1 amount goes on Line 5a and the Box 2a amount goes on Line 5b.3Internal Revenue Service. 1040 (2025) Instructions
Two additional consequences can follow. Under IRC Section 72(q), a distribution from an annuity contract before age 59½ carries an extra 10% penalty on the taxable amount. And if the understatement of tax is large enough, the IRS may add a 20% accuracy-related penalty under Section 6662.8Office of the Law Revision Counsel. 26 U.S. Code 6662 – Imposition of Accuracy-Related Penalty on Underpayments Both are avoidable by verifying the 1099-R before filing and correcting any wrong code with the carrier.
Records to Keep After You File
Reporting the exchange as tax-free rests on basis carryover. Your investment in the old contract transfers dollar for dollar to the new contract under IRC Section 1031(d), reached through the cross-reference in Section 1035(d), with adjustments for any cash received and any gain or loss recognized.9Internal Revenue Service. Notice 2011-68 – Annuity Contracts When you eventually surrender the new contract or begin receiving annuity payments, you will need to prove that basis to avoid being taxed on money already taxed once.
Keep a permanent file with the original contract application and premium records, the 1099-R with Code 6, the new contract’s policy documents, and any statement attached to your Form 1040. If you do a chain of exchanges over time, the basis chain runs back to the earliest contract. Losing the original premium records at any link means you may not be able to prove basis when the final distribution occurs, and the IRS will tax the entire payout as ordinary income. The exchange that feels like paperwork today is the tax document you will need decades from now.