Regretting Your Annuity? The Tax Rule That Can Move You Without Triggering IRS Tax

A tax provision dating back to 1954 can help you leave an annuity you no longer want without creating an IRS bill, but one expensive feature of the old contract does not disappear. Before you agree to a swap, make sure you understand what the exchange will not erase.

Many retirees buy an annuity and later wish they had not. The fees can be higher than expected, the payout may be weaker than hoped, or an income rider may no longer suit the plan. Surrendering the contract outright can produce a tax bill on years of deferred gains. A separate rule in the Internal Revenue Code, often known as a 1035 exchange, can allow an owner to transfer from one annuity to another without immediately recognizing gain.

Interest-rate conditions are one reason this issue keeps coming up. People who purchased contracts in lower-rate periods often compare those terms with newer products. The tax rule can make a switch possible, but it is only one factor in the decision.

What Section 1035 Allows

Under 26 U.S.C. § 1035(a)(3), no gain or loss is recognized when “an annuity contract [is exchanged] for an annuity contract or for a qualified long-term care insurance contract.” A life insurance policy can also be exchanged for an annuity under § 1035(a)(1). The opposite direction is taxable: Treasury regulations state that the provision does not apply when an annuity is exchanged for life insurance, and in that case “any gain or loss shall be recognized.”

The same regulation, 26 CFR 1.1035-1, limits annuity-to-annuity exchanges to situations in which 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), meaning that extra value may be taxed.

Why the Money Must Move Directly Between Insurers

The exchange works when the old insurer sends the contract value directly to the new insurer. If you surrender the contract 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 income on the contract” under § 72(e)(2)(B)(i). Younger owners can also run into § 72(q)(1), which adds a 10% tax on the taxable portion unless an exception applies.

IRS Publication 575 says a transfer to a different company is reported on Form 1099-R with code “6” in box 7, and “You need not report this on your tax return.” The publication also describes a narrow election under Rev. Proc. 92-44 for certain cases 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 paid into the old contract becomes your basis in the new one. The deferred gain remains until you later withdraw funds or annuitize. Publication 575 also says the purchase date of the new contract is the date you bought the annuity you exchanged, which matters for the immediate-annuity exception to the early-distribution tax.

Hypothetical example: A retired teacher paid premiums into a deferred annuity years ago, and the contract is now worth far more than her total payments. If she exchanges it, her original premiums become her basis in the new contract and the growth remains tax-deferred. If she cashes out instead, that growth is taxable in the year she surrenders the policy.

Partial Exchanges

You do not have to move the entire contract. IRS Revenue Ruling 2003-76 treats an exchange 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 attract IRS scrutiny. Before taking money out, check the timing with a tax professional.

Costs That Still Remain

The exchange avoids income tax on the transfer itself, but it does not erase surrender charges on the old contract. If you are still within the surrender period, the insurer will collect its charge before the money moves. The new contract may also begin a fresh surrender schedule, locking up your money for additional years. Questions to ask before signing include:

• What is the current surrender charge on my contract, and when does it reach zero?
• What are the total annual costs on the new contract, 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 penalty?
• Which riders or death benefits would I give up? 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 vary.
• How is the person recommending the swap paid? A replacement sale usually generates a new commission.

Who May Benefit, and Who Should Hold Off

An exchange often makes sense for owners whose surrender period has 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 fit someone moving from a contract designed for growth into one designed for income, or into a qualified long-term care insurance contract.

Waiting may be wiser if a large surrender charge still applies, if the new product’s main attraction is a bonus that resets the surrender period, or if you would give up an income or death benefit rider worth more than the new features. In those situations, keeping the contract until the surrender period ends may cost less than switching now.

As you compare offers, keep an eye on rates. Shifts in Treasury yields can change the terms of new contracts quickly. 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, before you sign transfer paperwork.