“1035 exchanges allow people who own an annuity to swap it tax-free for another annuity. They don’t work well for everyone, however.” Robert Layman
A common problem with an annuity contract is that it can be extremely challenging to get out of one once you have it. This is because you may incur significant surrender charges or have to pay a ton of tax on your gains.
For this reason, the IRS developed the “1035 Exchange,” named after a section of the tax code. 1035 exchanges allow an annuity owner to swap their current contract for a new one, tax-free. As people’s needs and goals evolve, they may decide that their current annuity no longer works. In that case, they can use a 1035 exchange to swap their existing contract for another one.
1035 exchanges may be a helpful tool for those who have built up significant gains that taxes could decimate if they cashed in their annuity. However, they are not a good choice for everyone.
1035 exchanges may work if:
- Your new annuity contract comes with a bonus toward the value of your contract. This bonus can range from 1 to 5 percent of purchase payments.
- The annuity you want to buy has valuable new features. This idea is particularly applicable if you have a variable annuity. A new variable annuity could cost less or have better death benefits.
- You would rather have a fixed index annuity than your current variable annuity.
- A new contract could mean lowered expenses or better investment choices.
- You have an annuity with a company that isn’t as financially strong as before and want to change to a higher-rated company.
- Your new fixed annuity offers a better rate than you currently have.
Even if one of these situations is applicable,you still need to be cautious when opting for a 1035 exchange. If your advisor has recommended a 1035, you should do your research and ask them some key questions such as:
- What will be the TOTAL cost of doing a 1035 exchange?
- How will this transaction change my surrender period or other terms?
- Are the features offered by the new annuity something I want or need?
- Can you demonstrate how the increased cost is worth it?
- How does this transaction fit my overall retirement needs and goals?
If you decide to proceed with your 1035 exchange, you must be careful to adhere to strict guidelines established by the IRS. For example, you won’t be able to cash out an old annuity and use the proceeds to buy a new one. The transaction would not count as a 1035 exchange if you did that.
Instead, the IRS will designate the cash you got from the old annuity as “realized income.” Realized income is money not converted into cash flow. Realized income is considered taxable, and you cannot use it in a 1035 exchange. Instead, you’ll have to contact the provider of the new annuity you wish to purchase and tell them you want to do a 1035 exchange.
They will then send you the paperwork needed for the exchange, which typically includes an application, compliance forms, and a letter to your current annuity provider. Your advisor should assist you in ensuring the paperwork is entirely correct and transmitted to the right person.
When the appropriate paperwork is signed, reviewed, and submitted, the old annuity company and the new annuity company will handle the transaction from then on.
Bottom line: Just because you can swap one annuity for another does not mean that it is always your best choice. It’s critical that you do your own research and consider all the potential outcomes. You should only consider a 1035 exchange