^Let me answer your questions, as best I can understand them. (You might also want to check out IRS Pub 590 - Individual Retirement Arrangements, IRS Pub 575 - Pension and Annuity Income, and the instructions for IRS Form 5329 (which is where the 10% penalty is calculated and reported on the 1040.)
"Annuities in general, outside of an IRA have a 10% withdrawal tax prior to 59.5. IRAs also have a 10% penalty. Money can flow out of an IRA annuity without a 10% early withdrawal penalty as long as it stays in an IRA." These are all true statements. And if you take it out of the IRA, there is only one 10% penalty. You don’t get a penalty for the annuity and another one for the IRA.
" So if you have an IRA variable annuity and you take advantage of a 10% free withdrawal provision of a specific annuity prior to 59.5 and roll those funds into a traditional IRA, there is no tax on the transfer?" Again, there’s no tax on withdrawal from an annuity inside an IRA. Transferring money from one IRA to another IRA is not a taxable event. (Beware that you can only do one rollover every 365 days, though. But that’s a separate issue.)
"Okay, and now, not talking about IRAs at all. 1035 exchanges allow you to switch from one annuity to another, tax free. Can funds from a free withdrawal provision be put in another annuity without triggering a 10% early withdrawal penalty?" As far as I know, there is no such thing as a “free withdrawal provision” in the tax code. It may be free of fees charged by the insurance company, but for tax purposes, a withdrawal is a withdrawal, and is subject to a 10% penalty.
"I purchased an annuity with high fees inside an IRA. How can I minimize the damage?" The obvious (and incredibly un-helpful) answer is, “Don’t buy an annuity, especially inside an IRA.” But the good news is that there aren’t any tax consequences. You can still take funds out of the annuity without taking them out of the IRA and incurring any penalties. Whether it makes sense to do so is entirely dependent on the individual’s circumstances, including the annuity fees, the client’s age, the death benefits, the living benefits, etc. etc.
"I purchased an annuity with high fees OUTSIDE of an IRA. How can I minimize the damage." Short answer–you can’t. You can 1035 exchange the annuity, but you have to buy another annuity. Moreover, it has to be an actual exchange of policies. You can’t receive cash and then purchase another annuity. That would trigger a taxable event, and IRC Section 1035 would not apply. (Note however that you can do a partial annuity exchange, which might be advisable if you have an annuity that has greatly appreciated in value.)
Good news/bad news - Not all of the withdrawals from an annuity are considered to be taxable income. The return of your investment is simply a recovery of basis and isn’t subject to any type of tax (neither ordinary income tax nor 10% penalty). However, before you can withdraw any basis, you have to withdraw all of the income. (EG - Five years ago, I purchased a $50k annuity. Today, it is worth $90k. I withdraw $30k. The $30k is taxed at ordinary tax rates + the 10% penalty. I still have $50k of basis and $10k of income remaining in the annuity.)
More bad news - IRA distributions allow you take distributions prior to 59.5 if you have medical payments, buying a house, or higher educatio expenses. This is not true with annuity payments. The only ways to get out of the early withdrawal penalty are 1.) Death, 2.) Total disability, or 3.) Annuitization.