What Is a 1035 Annuity Exchange
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Have you purchased a variable annuity in the past and later thought, maybe I should have picked a different one? You don’t have to take a tax hit to get out of your variable annuity when you use a 1035 annuity exchange. This tax trick allows you to switch annuities without triggering taxes. Thanks to something called a 1035 exchange.
So, what is a 1035 annuity exchange? And when should you consider using it?
A 1035 exchange (named after Section 1035 of the Internal Revenue Code) allows you to transfer funds from one annuity to another without paying taxes on any interest or gains at the time of the exchange.
Let’s say you bought an annuity 10 years ago. It’s grown in value, but it’s no longer meeting your needs. Maybe the interest rate is low, or the income options are limited. If you were to cash it out, you’d owe ordinary income taxes on the gains. But with a 1035 exchange, you can move that money directly into a new annuity, tax-deferred.
It’s like doing a trade-in on your financial vehicle except the IRS doesn’t make you pay tax when you upgrade.
Key Rules for a Valid 1035 Exchange
To qualify for tax deferral, the exchange must meet the following criteria
- Like-to-like transfer: This means whoever is listed as an annuitant on the first annuity must also be listed as an annuitant on the new annuity.
Annuitants cannot change without a taxable event so ownership and listed annuitants must be the same on both the old and new policies. You can exchange the cash value of an annuity or the cash value in a life insurance policy for a new annuity, but the insured or annuitant must transfer to the new annuity as it was set on the original policy. - Direct transfer only: The funds must move directly from one insurance company to another. You can’t take possession of the money, even for a day.
- Same owner and annuitant: The owner and annuitant on the old contract must be the same on the new one. If you want to change ownership, you need to do that first before transferring so that the ownership and annuitant matches. You cannot change annuitants without a taxable event.
If these conditions are met, the exchange qualifies under Section 1035, and you avoid paying taxes on the growth at the time of transfer.
When Should You Use a 1035 Exchange?
Here are some common situations where a 1035 exchange might make sense:
Better Rates or Terms
If your current annuity is out of surrender charge and earning a low fixed interest rate, and a newer contract offers a better rate or higher payout, it might be time to upgrade. This is especially common with Multi-Year Guaranteed Annuities (MYGAs) when the fixed rate period expires.
Adding Income Features
If your original annuity contract didn’t come with a lifetime income rider, but now you want income to help cover retirement expenses a 1035 exchange lets you move your contract value into a newer annuity with an income component. If you already have an income annuity but haven’t started income, you should get updated quotes to make sure you get the highest income when it is time to start the payments.
Simplifying or Consolidating Accounts
If you own multiple annuities and want to simplify your finances, you can use a 1035 exchange to consolidate them into a single annuity. Just be sure the new one meets your needs and provides better rates or features than your existing annuities.
Changing Insurance Companies
If your current insurer has weak financial ratings or poor customer service, you may want to move your money to a more reputable company. A 1035 exchange allows you to do that without paying taxes.
What to Watch Out For
While a 1035 exchange can be a smart move, it’s not always the right one. Keep these in mind:
- Surrender charges: If your current annuity is still within its surrender period, you will face hefty fees for leaving early. Generally speaking you should not move your annuity during the surrender period. Most insurance companies will not transfer your money into a new annuity if your surrender charge is higher than 3% of the value of the annuity.
- New surrender period: The new annuity will likely come with its own surrender schedule. Make sure it fits your time horizon.
- Losing benefits: You may lose existing features or guarantees, like death benefits or higher income payouts. Evaluate what you're giving up before completing a 1035 exchange.
A 1035 exchange is a powerful, IRS-approved way to improve your annuity situation without creating a tax bill. It gives you the flexibility to adjust your financial plan as your life goals and market conditions evolve.
But like any financial move, completing a 1035 exchange requires careful thought and an annuity agent who knows how to get the transfer done. Working with an inexperienced agent can cause problems, so schedule a call with My Annuity Agents to compare contract features and make sure a1035 annuity exchange is right for you.