How to Exchange an Annuity for another Annuity

Some annuity plan holders entertain the idea of replacing their current contract for another because of various reasons such as poor performance, or they simply have found one which better suits them or with better provisions.  If you are like one of them, think first before jumping in.  There are costs and other implications.

Surrendering variable annuities may mean assessment of applicable federal and state taxes on profits you may have gained from the contract.  This is in addition to the surrender charges your current provider might charge you.  And if you are 59 years old or younger, the IRS may want another 10%.  All these could cost you up to 60% of you total annuity contract.

There is, however, a practical and legal way to avoid all these. The IRS, under certain conditions, allows exchange of one annuity for another without incurring tax liabilities, although any surrender charges from the current insurance company may still apply.  This can be found on section 1035 of the Internal Revenue Code.  This provision is simply known as the 1035 Exchange.  Under this provision, funds from the old contract must be passed on directly to the new policy.  The policy-holder cannot accept payment for the surrender of the old plan even if it is for the purpose of buying the new one.  The annuitant also has to be the same in both contracts although changes may be made once the exchange is complete. The code sets no limit as to the number of annuities you can exchange.

When is it a good idea to make an exchange under the 1035 law?  One is when you realize that you prefer a fixed deferred plan over a variable one.  Also, you may want to do it when you want to take advantage of policies that offer better benefits like bonus riders, other investment options, lower charges and enhanced living or death benefits.  Or if your current policy does not provide for beneficiaries in case of your untimely death, you may want to discard it for one that does.

Under 1035 exchange, outdated variable annuities may be swapped with more efficient current ones without necessarily giving up your privileges to defer income tax payments on gains.

On the other hand, when do you avoid the 1035 exchange?  For one, it may not be a good idea when the bonus credits provided for in the old contract are wiped out by the old contract’s surrender charges and the benefits you will gain will not be worth it.  Also, why make an exchange when you do not need the fancy features that come with a new plan or if you will just incur higher expenses?  Likewise, if your current policy is worth less than what you paid for, you may be better-off just surrendering it and taking the tax loss. This is a better option if you are at least sixty years old.

When you make the exchange, surrender schedules will be reset to begin with the affectivity of the new policy.  Consider also the other charges that may accrue.  Weigh all the pros and cons and do it only if it will clearly benefit you.  If you are unsure, consult a financial advisor.

Annuities are best suited for long term investors.  Any withdrawal prior to age 59 ½ is subject to a 10% tax penalty as well as regular income tax.  Annuities often also have a surrender schedule, meaning that withdrawals may be subject to a penalty by the insurance company if not left in for a predetermined amount of time.  Any guarantees on principal invested is based upon the claims paying ability of the underlying insurance company.