The 1035 Exchange
If you are reading this chances are you are considering exchanging one annuity for another. “Section 1035 of the U.S. Tax Code” is the method used to enact the exchange and there are a few important things you should know if this is an option you are considering.
1035 exchanges enable you to move from one annuity to another without paying taxes. As is usual when dealing with the IRS, things can get complicated quickly if not done correctly and can end up costing you time and aggravation and probably some fees. Do your research (reading this article is a good start) and consult your financial advisor. If you are affecting a particularly complicated exchange, such as one variable annuity for another or a partial 1035 exchange, you may also want to consult a tax professional.
You should only consider 1035 exchanges when you know that you are getting a definite benefit from the new product. Think of it like trading in your old car for a new one. Sure your old car runs fine and is still reliable, but a new car may have GPS, satellite, better gas mileage, longer warranty, etc. You get the point I’m sure. You may have heard some horror stories about unscrupulous sales people preying on the unsuspecting, stories which may say that advisors will try to get you to exchange your annuity for another, just so the salesperson can get a fat commission. In reality, this is uncommon and easily avoidable. The truth is the industry is self-regulating to a certain extent. Once you and your trusted financial advisor have thoroughly discussed the exchange you will fill out a form, often called a “suitability form,” that defines the reasons for the exchange; listing all of the benefits and any draw-backs that may be perceived but are deemed negligible in light of the benefits you will gain. This form is reviewed by a broker at the insurance company (not the person who is selling you the new annuity) and if it is deemed that there is little or no benefit to you, your 1035 exchange may be disallowed. Again, make sure you fully understand all of the benefits and any draw-backs before making the exchange and remember: if your annuity is performing well, is stable and is meeting your needs, you probably don’t need to exchange it. Here are some good questions/points to ask:
- What (if any) costs will I incur for this exchange?
- Compare the features of my existing annuity with the annuity I am considering.
- Will you get a commission on this exchange? How much will that be?
- Please make a comparison between my existing surrender period and death benefits with the same from the new product.
Let’s look at a situation where it might be advisable to exchange your old annuity for a new one:
You bought a 10 year deferred fixed-indexed annuity with after tax dollars that was earning what you thought was a great rate at the time of 3%. Your surrender period is up after 6 years and you are interested in a hybrid annuity (or equity indexed) that is paying a minimum of 5% per year. You currently have no need for steady income from the annuity and simply want to continue to grow your money until you retire. In this instance, exchanging your old annuity for the new product may make a lot of sense, as long as you plan on holding the new annuity long enough because your new annuity will most likely come with a new surrender charge period (and will also come with new death benefits). Always remember, annuities are for long term retirement planning. The gains you make on the exchange could be completely wiped out if you are forced to take the money out of your new policy within the new surrender period. This could be made worse if you are under 59 ½ when you take a disbursement because the IRS will penalize you 10% for early withdrawal.
You probably won’t be surprise to learn that you cannot exchange an annuity that has already been converted to an income stream (you have “annuitized”). However, any kind of deferred annuity can be exchanged for any other kind of annuity. Let’s take a look at another situation:
You put $100,000.00 after-tax dollars into a deferred annuity of some kind and over time it has earned $100,000.00 in interest. If you were to annuitize, the first $100,000 in disbursements would be taxed as normal income at whatever your tax rate was at the time. If you made a partial exchange of $100,000, only the first $50,000.00 would be taxable and you would be able to access the rest tax free much faster than if you had annuitized the whole amount. Continuing to defer the remaining $100,000.00 until the first portion had run out would further minimize your taxes as you will probably be in a lower tax bracket at that time.
Partial 1035 exchanges can be complicated, but in certain situations they can be extremely useful. The first thing of note is that Uncle Sam –as of October 24th, 2011- has changed the restrictions on a partial 1035 exchange. Prior to that date you had to wait a whole year before taking any disbursements from the exchange. Now it’s down to 180 days. This is helpful because you can plan your disbursements to occur within a given tax year, whereas previously it might have been spread over two tax years, possibly causing problems with your financial planning. I’ll say it again; if you think you might want to affect a partial exchange consult a tax professional. All warning aside, knowing what your income will be in advance can help you plan appropriately and save you some tax – hopefully you can achieve your partial exchange to coincide with a time in your life when you are in a lower tax bracket.
Lastly, don’t expect a 1035 exchange to happen overnight. Chances are there will be two different insurance companies involved and mountains of paperwork. Plan accordingly for several weeks delay and make sure that all important “paperwork” was done professionally. If you have asked all the right questions and are getting a better product you should have your 1035 completed without problems.