Cashing in an annuity usually produces taxable income. Additionally, if you surrender your annuity before the contract term is up, often there’s a surrender charge.
But you aren’t stuck for years if you have a low-paying annuity or even a type of annuity, such as a variable annuity, that no longer meets your needs. You can make a tax-free 1035 annuity exchange. You can trade in an entire annuity or part of it for a better annuity at a different insurance company.
A 1035 exchange lets you switch companies while continuing to defer taxes, ensuring that your annuity stays up-to-date with the latest advantages, benefits and best rates available.
Sign up for Kiplinger’s Free E-Newsletters
Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.
Profit and prosper with the best of expert advice - straight to your e-mail.
It’s one of the few parts of the tax code that work in your favor. Accumulated interest earnings from your original policy remain tax-deferred until you withdraw the funds from your new annuity sometime in the future. In contrast, surrendering an annuity is a taxable event and you must recognize any gain as current income.
A full 1035 exchange most often involves exchanging one fixed-rate annuity at the end of its surrender term for a better-paying fixed annuity. You can often get a higher interest rate than the renewal rate offered by your current insurer.
And you can exchange among types of annuities. For instance, if you want to lower your risk profile, you can exchange a variable annuity for a fixed annuity that guarantees principal. It’s a simple process. The funds go directly from the current insurer to the new one.
Partial 1035 exchanges
Partial exchanges provide additional flexibility. Anyone unhappy with a current annuity that’s still subject to a surrender charge can usually take advantage of the penalty-free withdrawal provisions of their existing contract. Most annuities let you withdraw 10% annually without penalty. Instead of taking receipt of the penalty-free withdrawal amount, you can move it to a new annuity via a partial 1035 exchange.
Many fixed-rate annuity owners move their penalty-free amount annually from a lower-interest-rate product bought years ago to a higher-paying current annuity. Some are doing partial exchanges from variable and fixed-indexed annuities into fixed-rate multi-year guarantee annuities (MYGA).
Caution must be exercised when executing a partial 1035 exchange. There’s a special IRS rule when using non-qualified funds (money not in a retirement plan) in a partial exchange. If any withdrawals are made from either contract within 180 days of a partial exchange, the exchange is invalidated and becomes a taxable event.
Life insurance policy can be exchanged for an annuity
Many older people have paid-up cash-value life insurance policies that they no longer want or need. Section 1035 lets you exchange such a policy for an annuity tax-free.
You could use the cash value to buy any type of annuity. One good choice is a deferred income annuity, which will pay an individual or a couple a guaranteed lifetime income starting at a date the owner chooses.
As with any 1035 exchange, the insured or annuitant and the owner(s) of the life insurance policy and the new annuity must be the same. This IRS rule prevents someone from passing their tax liability on any untaxed gain in the policy to another person.
All 1035 exchanges, whether full or partial, require serious thought. Only after careful examination of available alternatives can you decide if a 1035 exchange makes sense for your individual situation.
My firm offers a free 1035 exchange-evaluation service that compares an existing annuity to newer products on the market.
-
If You'd Put $1,000 Into Berkshire Hathaway Stock 20 Years Ago, Here's What You'd Have TodayBerkshire Hathaway is a long-time market beater, but the easy money in BRK.B has already been made.
-
New SALT Cap Deduction: Unlock Massive Tax Savings with Non-Grantor TrustsThe One Big Beautiful Bill Act's increase of the state and local tax (SALT) deduction cap creates an opportunity to use multiple non-grantor trusts to maximize deductions and enhance estate planning.
-
New SALT Cap Deduction: Unlock Massive Tax Savings with Non-Grantor Trusts
The One Big Beautiful Bill Act's increase of the state and local tax (SALT) deduction cap creates an opportunity to use multiple non-grantor trusts to maximize deductions and enhance estate planning.
-
Know Your ABDs? A Beginner's Guide to Medicare BasicsMedicare is an alphabet soup — and the rules can be just as confusing as the terminology. Conquer the system with this beginner's guide to Parts A, B and D.
-
I'm an Investment Adviser: Why Playing Defense Can Win the Investing GameChasing large returns through gold and other alternative investments might be thrilling, but playing defensive 'small ball' with your investments can be a winning formula.
-
Five Big Beautiful Bill Changes and How Wealthy Retirees Can BenefitHere's how wealthy retirees can plan for the changes in the new tax legislation, including what it means for tax rates, the SALT cap, charitable giving, estate taxes and other deductions and credits.
-
I'm a Financial Planner: Here Are Five Smart Moves for DIY InvestorsYou'll go further as a DIY investor with a solid game plan. Here are five tips to help you put together a strategy you can rely on over the years to come.
-
Neglecting Car Maintenance Could Cost You More Than a Repair, Especially in the SummerWorn, underinflated tires and other degraded car parts can fail in extreme heat, causing accidents. If your employer is ignoring needed repairs on company cars, there's something employees can do.
-
'Drivers License': A Wealth Strategist Helps Gen Z Hit the RoadFrom student loan debt to a changing job market, this generation has some potholes to navigate. But with those challenges come opportunities.
-
Financial Pros Provide a Beginner's Guide to Building Wealth in 10 YearsBuilding wealth over 10 years requires understanding your current financial situation, budgeting effectively, eliminating high-interest debt and increasing both your income and financial literacy.
