Regret Your Annuity? The Tax Break That Can Let You Change Contracts Without Owing the IRS

Quick Read

• Section 1035 allows annuity holders to exchange contracts without immediately recognizing gain, but taking the money yourself and redepositing it can trigger taxes on the earnings.

• An exchange does not eliminate surrender charges on the old policy, and the replacement contract may begin a new surrender period that keeps your funds locked up.

• The rule is most useful for owners whose surrender period has ended and whose current contract is expensive, while those facing heavy charges or giving up valuable riders may be better off waiting.

Many retirees buy an annuity and later decide it is no longer the right fit. The fees may be higher than expected, the rate may look disappointing, or the income rider may not match the retirement plan anymore. Surrendering the contract can also create a tax bill on years of deferred gains. One alternative in the tax code, often called a Section 1035 exchange, allows an owner to move from one annuity to another without recognizing gain on the swap.

Interest rates are one reason the issue keeps coming up. The 10-year Treasury yield recently stood at 4.90%, down from 5.28% about a month earlier. People who bought contracts in lower-rate periods often compare those terms with newer products. The tax rule can make a change possible, but it is only one part of the decision.

What Section 1035 Allows You to Exchange

Under 26 U.S.C. § 1035(a)(3), no gain or loss is recognized when an annuity contract is exchanged for another annuity contract or for a qualified long-term care insurance contract. A life insurance policy can also be exchanged into an annuity under § 1035(a)(1). The reverse is treated differently: Treasury regulations say the rule does not apply when an annuity is exchanged for a life insurance contract, and in that situation any gain or loss must be recognized.

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The same regulation, 26 CFR 1.1035-1, limits annuity-to-annuity exchanges to cases where the same person or persons are the obligee or obligees under both contracts. If you receive cash or other property along with the new contract, the regulation points to section 1031(b) and (c), which means the extra value can be taxed.

Why the Funds Must Move Directly Between Insurers

The exchange works when the old insurer sends the contract value straight to the new insurer. If you surrender the annuity and deposit the check yourself, that is treated as a withdrawal. Amounts taken out before the annuity starting date are included in gross income to the extent allocable to earnings on the contract under § 72(e)(2)(B)(i). Younger owners may also face § 72(q)(1), which adds a 10% tax on the taxable portion unless an exception applies.

IRS Publication 575 says an exchange with a different company appears on Form 1099-R with code “6” in box 7, and that you do not need to report it on your tax return. The publication also discusses a narrow election under Rev. Proc. 92-44 for certain situations in which cash came out of the old contract and was reinvested. That option requires statements to the new issuer and attachments to a timely filed return.

Your Basis Carries Over

Section 1035(d)(2) refers to section 1031(d) for basis, so what you invested in the old contract becomes your basis in the new one. The deferred gain remains until you later withdraw money or annuitize. Publication 575 also notes that the new contract’s purchase date is the date you originally bought the annuity you exchanged, which matters for the immediate-annuity exception to the early-distribution tax.

Partial Exchanges

You do not have to move an entire contract. IRS Revenue Ruling 2003-76 treats a transfer of part of an annuity contract into a new annuity contract as tax-free under section 1035. Basis is divided between the two contracts, and withdrawals soon after a partial exchange can draw IRS scrutiny. It is wise to check the timing with a tax professional before taking money out.

Costs That Still Apply After the Swap

The exchange can avoid income tax on the transfer itself, but it does not erase surrender charges on the old contract. If the surrender period is still in effect, the insurer will take its charge before the money moves. The new contract may also begin a fresh surrender period, keeping your money tied up for additional years. Before signing, consider these questions:

• What is the surrender charge on my current contract, and when does it fall to zero?

• What will the new contract cost each year in total, including base fees, rider fees and any fund expenses?

• How long is the new surrender schedule, and how much can I withdraw each year without a penalty?

• Which riders or death benefits would I lose? An enhanced death benefit or an income rider with a built-up benefit base usually stays with the original insurer.

• What backs the guarantee? Guaranteed income or minimum rates depend on the insurer’s claims-paying ability, and state guaranty association limits differ by state.

• How is the person recommending the swap paid? A replacement sale often generates a new commission.

Who Gains From an Exchange, and Who May Want to Hold Off

An exchange is often a better fit for owners whose surrender period has already ended or is close to ending, whose current contract has high ongoing fees and no valuable rider, and who have the new contract’s costs, terms and surrender schedule in writing. It can also suit someone who wants to move from a growth-oriented contract to one designed for income, or into a qualified long-term care insurance contract.

Waiting may make more sense if you still face a steep surrender charge, if the new product’s main appeal is a bonus that restarts the surrender clock, or if you would give up an income or death benefit rider worth more than the replacement’s features. In those situations, keeping the current contract until the surrender period ends may cost less than switching now.

Keep an eye on rates while comparing offers. The recent drop in the 10-year yield from 5.28% to 4.90% shows how quickly new contract terms can change. Before signing transfer paperwork, ask for the replacement’s surrender schedule and a written list of every fee and rider charge, along with a side-by-side comparison against your current contract.

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If you’ve saved over $1,000,000, this guide is for you. The last thing you want in retirement is to run out of money, you want your money to generate lasting income while you enjoy your life.

Now you can learn the strategies wealthy retirees use to fund their retirement with The Definitive Guide to Retirement Income from Fisher Investments. Download the guide today! (sponsor)