Do a Tax-free 1035 Exchange of Your Old Annuity for a New One
By Shane Flait © 2011

If you have an old deferred annuity but feel that a new deferred annuity will serve you better, you can exchange the old one for the new one tax free. But you better consider if you’re really better off doing so. That’s what this article is about.

You can exchange one annuity for another, but you, as a retiree, need to watch out for what you may lose in the process.  Often when you have one investment and see a similar but better version of it, you wonder if you can ‘upgrade’ to the new and improved version.  Generally, whenever you sell an investment, you need to pay taxes on its gain. If, next, you buy another investment your cost of the new investment will be its tax basis until it’s sold in the future to determine its gain.

However, in the case of two investment of ‘like kind’, the U.S. tax code, section 1035 allows you to simply exchange the two ‘like kind’ investments – if circumstances allow - so as not to have to pay tax until the latter investment is sold or pays out.  Two such investments avail themselves to this exchange process are real estate and annuities. In the case of annuities, you need to be aware of how your ‘new and improved’ annuity differs from your ‘old annuity. 

Section 1035 allows you to exchange an existing annuity contract for a new annuity contract without paying any tax on the income and investment gains in your current variable annuity account. These tax-free exchanges, known as 1035 exchanges, can be useful if another annuity has features that you prefer, such as a larger death benefit, different annuity payout options, or a wider selection of investment choices.

 

You may, however, be required to pay surrender charges on the old annuity if you’re still in its surrender charge period. In addition, a new surrender charge period generally begins when you exchange into the new annuity. This means that, for a significant number of years (as many as 10 years), you typically will have to pay a surrender charge (which can be as high as 9% of your purchase payments) if you withdraw funds from the new annuity.

 

Further, the new annuity may have higher annual fees and charges than the old annuity, which will reduce your returns.

 

So, if you’re thinking about a 1035 exchange, compare both annuities carefully. Unless you plan to hold the new annuity for a significant amount of time, you may be better off keeping the old annuity because the new annuity typically will impose a new surrender charge period.

 

Also, to keep the exchange ‘tax free’ have the insurance company(ies) do the exchange. Don’t you surrender the old annuity for cash and then buy the new annuity.

 

Retirees are probably better off sticking to fixed annuities since their performance is more stable and annuities are a long term investment.

 

 

Shane Flait is a writer and educator. See more at www.EasyRetirementKnowHow.com