Update Your Variable Annuity With Section 1035

By George D. Lambert AAA

Do you own a variable annuity? You may have thought about surrendering it because of poor performance, or because you found another investment that looks better. But before you cash in your contract, let's take a close look at what that move could cost you.

When you surrender a variable annuity:

  • You will owe ordinary income tax (up to 35% federal tax and state tax if applicable) on any profit you have within the contract
  • The annuity company might hit you up with a surrender charge (which could be as high as 15%)
  • The IRS will want another 10% as a penalty if you are less than 59.5 years old

That means you could possibly lose a whopping 60 cents - or more - out of every dollar on some portion of your annuity contract.

But thanks to a special clause in the tax code, there is an alternative strategy that can eliminate all or at least some of this pain. Investors who are holding or even considering annuities should make themselves familiar with this valuable financial planning tool. (Keep reading about the complexities with variable annuities in Getting The Whole Story On Variable Annuities and Are You Buying Annuities Or Mutual Funds?)

The 1035 Exchange
Under Internal Revenue Code Section 1035, the IRS will let you exchange one annuity for another one, income-tax free. The catch is that the funds must pass directly from the old annuity contract to the new annuity contract. In other words, you cannot accept a check for the old annuity to buy the new one.

You'll also have to keep the owner and annuitant on the new contract the same as under the old contract, although you can change these once the exchange is complete. In addition, there is no limit on the number of old variable annuity contracts you exchange for new contracts.

When the Exchange Is a Good Idea
A 1035 exchange might be an option to consider if you may decide that you no longer need a variable annuity and now prefer a fixed deferred annuity. Or, maybe you like fixed-indexed annuities.

In addition, annuity companies are constantly changing and expanding the options in their products. For instance, many now offer:

  • Bonuses ranging from 1-5% for each premium you make
  • More investment options, such as those that take advantage of international markets
  • Lower expenses
  • Enhanced living benefits, such as the guaranteed lifetime withdrawal benefit (GLWB)
  • Enhanced death benefits, like lifetime income payments to beneficiaries

And when you use a 1035 exchange, you can swap outdated variable annuity contracts for more current and efficient ones while continuing to defer the income tax on the gains.

When To Avoid the Exchange
Exchanging your variable annuity might not be a good idea if:

  • The bonus gets wiped out by the extra charges the annuity company tacks on
  • You don't need the fancy features that come with the new contract
  • The fees for the new contract are higher than those on the old contract
  • Your current contract is worth less than you paid for it. In this case, you might be better off surrendering it - assuming the surrender charges are gone and you're over 59.5 - and then taking the tax loss.

Also, realize that your broker may be getting paid a high commission for selling you a new annuity when a low-commission product, such as a stock, bond or mutual fund might accomplish your needs.

Furthermore, any investment you make in a variable annuity should be made with the understanding that you are willing to pay for the insurance part of the contract. Otherwise, a straight equity or fixed income investment would be more advisable.

The Risks
Even though a 1035 exchange lets you transfer money income-tax free and the new contract sounds enticing, you may be losing - not gaining - if you make the exchange.

For example, suppose you've owned your variable annuity for a long time and the surrender charges are finally gone. Now you're about to retire and have counted on using your variable annuity to supplement your income.

If you exchange your annuity for a new one, the surrender charges will start all over again - maybe for as long as 15 years. In this case, you might sacrifice several percent every time you take money out. Some annuity companies, however, 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:

Salespeople must tell you in easy-to-understand language the pros and cons of the exchange. They are permitted to recommend an exchange only if it is in your best interest and only after they've reviewed your personal situation, financial needs and risk tolerance.

In addition, many states and brokerage firms have forms to verify that you understand the 1035 exchange. The forms usually provide a comparison of the features and costs of your existing variable annuity to the new one. They can also give you a good idea of what to look for when an agent proposes a 1035 exchange. Most likely, you and your agent will have to sign the forms.

Even if you don't have to sign off on verification forms, make sure that you are 100% clear on specific points. For instance,

  • Costs - How much is your total cost for making the exchange? Find out about the annual cost as well as the long-term cost.
  • Features - Why do I need these new features? How much will each one cost annually?
  • Surrender Period - What is the surrender charge? How long does it last? What are my options for withdrawing money? Are they different than what I have with my old contract?

Finally, don't sign any exchange form or agree to exchange your annuity until you study all of the options carefully, have all of your questions answered and are satisfied that the exchange is better than keeping your current contract.

Conclusion
Variable annuities are long-term, retirement-oriented investment vehicles and exchanging them may not benefit you. Regulators are there to protect you, but you are the first line of defense. Examine the pros and cons of a 1035 exchange just as you would weigh any other important investment decision.

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