Exchange a Variable Annuity With Section 1035

With this clause you can exchange an annuity without paying income tax

Reviewed by David KindnessReviewed by David Kindness

Owners of a variable annuity may have thought about surrendering the contract because of poor performance or because another investment looks better. Alternatively, owners may be contacted by the annuity’s broker and encouraged to turn in their variable annuity for a new model. When does this make sense and what could such a move cost?

Surrendering a variable annuity generally means:

• The owner will owe ordinary income tax (up to 37% federal tax, as well as state tax if applicable) on any profit they have within the contract.
• The annuity company might levy a surrender charge, which typically starts at around 7%, and go down over time.
• The IRS will want another 10% as a penalty if the account owner is younger than 59½.

Thanks to a clause in the tax code, an alternative strategy can eliminate all or at least some of this pain. Investors who hold or who are considering annuities should make themselves familiar with this valuable tool to exchange an annuity.

Key Takeaways

• A 1035 exchange might be an option for someone who no longer needs a variable annuity.
• Annuity companies constantly change and expand options in their products.
• A broker or financial planner may get a high commission for selling a new annuity when a low-commission product such as a stock, bond, or mutual fund might work just as well.

The 1035 Exchange

Under Section 1035 of the Internal Revenue Code, the IRS will allow the exchange of one annuity for another income tax-free.

The funds must pass directly from the old annuity contract to the new one. In other words, the owner cannot accept a check for the old annuity to buy the new one. The owner and the annuitant on the new contract must also remain the same as under the old contract, though these can be changed once the exchange is complete.

There is no limit on the number of old variable annuity contracts that can be exchanged for new contracts.

Benefits of an Exchange

A 1035 exchange might be an option for someone who no longer needs a variable annuity and perhaps now prefers a fixed deferred annuity or a fixed index annuity. In addition, annuity companies constantly change and expand options in their products. Many now offer:

• Bonuses as high as 10% for each premium
• More investment options, such as those that take advantage of global markets
• Lower expenses
• Enhanced living benefits, such as the guaranteed lifetime withdrawal benefit
• Enhanced death benefits, such as lifetime income payments to beneficiaries

A 1035 exchange can also help when swapping an outdated variable annuity contract for a more current and efficient one while continuing to defer income tax on the gains.

When to Avoid an Exchange

Exchanging a variable annuity might not be a good idea if:

• The bonus is wiped out by the annuity company’s extra charges.
• The new contract has unneeded features.
• The fees for the new contract are higher than those on the old contract.
• The contract holder is older than 59½ and is taking the tax loss.
• Economic changes, such as lower interest rates, make the terms of the older annuity more favorable to the owner than the terms of the new annuity.
• The current contract is worth less than what was originally paid.

In the last case, the contract owner might be better off surrendering the annuity, assuming the surrender charges are gone.

Also be aware of the following: A broker or financial planner may be getting a high commission for selling a new annuity when a low-commission product such as a stock, bond, or mutual fund might work just as well. Alternatively, the annuity company may be pushing to get owners to surrender annuities established many years ago, when interest rates were higher than at present.

Furthermore, any investment in a variable annuity should be made with the understanding that one will pay for the insurance part of the contract. Otherwise, a straight equity or fixed-income security would be more advisable.

The Risks

Even though a 1035 exchange allows the transfer of money income-tax free and the new contract sounds enticing, an exchange carries risk.

For example, suppose surrender charges are finally gone on a long-owned variable annuity that a near-retiree has counted on to supplement their income. Exchanging that annuity for a new one starts the surrender charges all over again—maybe for as long as 15 years. If that’s the case, that retiree might sacrifice several percentage points every time they withdraw from the annuity. (Some annuity companies will occasionally waive surrender charges on variable annuities bought with a 1035 exchange. Be sure to ask.)

Regulatory Protections

Variable annuity sales and exchanges are one of the most highly regulated investments in the market. They are governed by the:

• Securities & Exchange Commission (SEC)
• Financial Industry Regulatory Authority (FINRA)
• State insurance commissioners
• State security administrators
• Brokerage firms’ compliance officers

Salespeople must relate in easy-to-understand language the pros and cons of the exchange. They are permitted to recommend an exchange only if it is in the consumer’s best interest and only after they’ve reviewed the annuity owner’s unique situation, financial needs, and risk tolerance.

In addition, many states and brokerage firms have forms to verify the consumer’s understanding of the 1035 exchange. The forms usually provide a comparison of the features and costs of an existing variable annuity to the new one. They can also give a good idea of what to look for when an agent proposes a 1035 exchange.

Important

A clause in the tax code allows you to exchange an outdated variable annuity contract for a more current and efficient one while continuing to defer income tax on the gains.

Even if not signing off on verification forms, an annuity owner should make sure to be clear on:

• Costs: What’s the total cost for making the exchange, annual as well as long-term?
• Features: Are they all needed? Why? How much will each cost annually?
• Surrender period: What’s the surrender charge? How long does it last? What are the options for withdrawing money? Do they differ from those of the old contract?

Finally, an annuity owner shouldn’t sign any exchange form or agree to exchange an annuity until studying the options carefully, getting all their questions answered, and feeling satisfied that the exchange is better than keeping the current contract. In some cases, the current contract may have more favorable terms. Don’t take the agent’s word for it that the new contract is better—especially if you are being pushed to make the exchange.

The Bottom Line

Variable annuities are long-term, retirement-oriented investment vehicles, and exchanging them is not to everyone’s benefit. Examine the pros and cons of a 1035 exchange just like any other important investment decision.

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