How do I transfer my variable annuity to a mutual fund without a big tax penalty?
I have $200,000 in a variable annuity series and would like to put it into a mutual fund. How do I do this without incurring a big tax penalty? The annuity will be mature in a couple of months. Are there transfer options?
Taxation will ultimately depend on whether this is a some type of IRA or a Non-Qualified Annuity. If it is an IRA you can easily transfer it to another account and invest in muutual funds. Make sure to check the surrender charges, and do what you can to avoid / minimize them.
If on the other hand you are in a non-qualified annuity you will need to stay in a non-qualified annuity or liquidate and withdraw the funds. Liquidating will be taxable on the gains - and if you are under 59 1/2 you will face that pesky 10% IRS early withdrawal penalty.
If you are in a variable annuity you can still choose sub account to invest similarly to mutual funds. If you are in a fixed annuity or equity indexed annuity you can 1035 exchange the policy to a new variable annuity to invest the way you want. Make sure to work with a fee only fiduciary financial planner to avoid getting sold the next annuity with the biggest commission. There are some newer fee only annuities with lower fees and no surrender charges.
Best of luck!
This is a really good question and something that comes up quite often. It is really important to understand whether your annuity is qualified or non-qualified. Don’t mistake these terms designating your annuity good or bad. These terms identify whether you have an annuity as part of an IRA (qualified) or non-retirement (non-qualified). The way each of these types of annuities are taxed are very different. For more information on how taxation works on various investments, you might want to read my article TAX-DEFERRED VS TAX-FREE INVESTMENT ACCOUNTS.
I will make an assumption that your annuity is a non-qualified annuity. If this is the case, you can only transfer via an IRS section 1035 exchange. This means the tax deferred earnings will remain intact only if your annuity is transferred to another non-qualified annuity.
If you were to transfer a non-qualified annuity directly to a mutual fund, you would likely incur tax on the earnings and potential penalties if you are under age 59 ½.
Please note that this should not be considered investment advice and is only educational in nature. Please be sure to consult with your own legal, tax, or investment advisor regarding your specific situation.
Best of luck!
David N. Waldrop, CFP®
It depends. What you want to avoid is a tax cost. Is this a Non-Qualified Annuity? If so, find out what your first investment was and what your account grew to. Those gains would be taxed as ordinary income plus a 10% penalty if you are under the age of 59.5. If your gains are substantial, you might want to research annuity companies. Some of them have products that are stripped down to any unecessary expensive benefits you might need which reduce the cost substantially.
If your annuity is within an IRA, then there are no cost to transferring to another custodian and buying mutual funds.
I hope this helps.
Generally speaking, the worst thing you can do is to take the money out of an annuity, especially a lump-sum, to use it or invest it in a taxable or brokerage account. You already know the reason why? Tax. If you’re under 59 ½, not only you pay the regular income tax, you need to pay an additional 10% penalty tax.
With so many annuities out there, and with an improved interest-rate (thanks to the recent several rounds of interest hikes), you have many options to do an exchange, from one annuity to another without any tax consequence. When do it right, it’s a wonderful way to complement your existing investments. Case in point, within 14 mo. of the investment, one of my clients’ annuity account had a $66k increase. Furthermore, the gains are locked in for future retirement withdrawals. Considering not many people have the pension any more, annuity can be a great way to create a lifetime stream of income. Think this way, a private annuity is your own private pension.
Depending on your age, tax status, guaranteed retirement income sources (pension, Social Security income, etc.), your financial planner can help you find an annuity to meet all those goals. Caveat: it’s difficult to compare annuity contracts even though they may mean the same thing (benefit, limitation, withdrawal rate, etc.). Thus, it’s paramount to find a trustworthy CFP® who have extensive knowledge about the annuity, investment, retirement planning, and tax to explain to you. Best!
The most important question to consider are your investment gains inside the annuity. If you have little to no gains versus your original cost basis then you can surrender your annuity, and fund a mutual fund in a brokerage account without significant tax penalty. If you are under the age of 59 1/2 then any gains that you withdraw will be assesed an early withdrawal penalty of 10%, and you'll have to pay ordinary income tax on those gains as well. But again, if you have little to no gains then you have minimal tax liability.
If you have significant gains in your annuity (and given the recent market then this is likely the case) then the situation is more complicated. Again, if you're under 59 1/2 then your gains will be both taxable and assessed the early withdrawal penalty, but you could do a partial withdrawal and spread out the tax liability over multiple years. With annuities, the earnings come out first so the full amount is taxable until you reach your cost basis, and then you can withdraw the entire cost basis amount without creating a tax liability. There are a couple of exceptions when it comes to avoiding the pre-59 1/2 distribution penalty:
- 72(q) distribution: requires you to take substantially equal payments for five years or until you turn 59 1/2, whichever is later.
- Annuitization: again you would have to satisfy the 72(q) rule above, but in an annuitization a proportionate amount of the annual payment is cost basis versus earnings. So if you have 60% cost basis in your annuity, then 60% of your withdrawal is cost basis. The annuitization could be for a "period certain" such as 10 years instead of your life distribution.
If you need to go down the path of the 72(q) calculation then talk to the insurance company as they will run the calculation for you.
If the annuity fees are a concern then you may find it advantageous to do a 1035 exchange to a low cost variable annuity like Jefferson National (now owned by Nationwide). The 1035 exchange creates no tax liability, and this particular annuity has no new surrender schedule. In addition, they're the lowest cost annuity option that I have seen in the market so far. From there you could start a withdrawal strategy like described above.
Please let me know if you have further questions, or if I can be of further assistance.
Good luck to you!