An immediate annuity cannot be exchanged for another immediate annuity. However, a tax-deferred annuity can be exchanged for another tax-deferred annuity, or an immediate annuity. This process is referred to as a 1035 exchange. The 1035 exchange refers to the section of the tax code that allows investors the flexibility to exchange one annuity for another without incurring any immediate tax liabilities. Generally the surrender of an existing insurance contract is a taxable event since the contract owner must recognize any gain on the "old" contract as current income. However, under IRS § 1035 when one insurance, endowment, or annuity contract is exchanged for another, the transfer will be nontaxable, provided certain requirements are met.
The owner and insured, or annuitant, on the "new" contract must be the same as under the "old" contract. However, changes in ownership may occur before or after the exchange is completed. The contracts involved must be life insurance, endowment, or annuity contracts issued by a life insurance company.
Any type of contract cannot be exchange for another type of contract. The following rules must be followed in order to avoid tax consequences:
"Old" Life Insurance Contract → "New" Life Insurance Contract
"Old" Life Insurance Contract → "New" Annuity Contract
"Old" Endowment Contract → "New" Annuity Contract
"Old" Annuity Contract → "New" Annuity Contract
An immediate annuity traditionally cannot be surrendered to an insurance company, whereas a tax-deferred annuity can. Upon surrender, the owner will receive a cash settlement amount which is likely to be reduced by an applicable surrender charge. The surrender charge is a percentage of the tax-deferred annuity's value, usually ranging from 15% to 1%. As a tax-deferred annuity contract ages the surrender charge continues to decrease, eventually reaching 0%.
There are a wide range of reasons someone may want to sell an annuity. The most common reason is that the individual needs a greater amount of income, or immediate access to their funds. Most annuities do not allow for either once payments have begun. For example, if an elderly individual enters a nursing home, he or she may not be able to afford the costs of such care because the income from his or her annuity is far too little. That individual can sell his or her annuity in order to obtain funds and plan for long-term care costs. It's important to keep in mind that the value received in exchange for the annuity can be substantially less than the return the individual would have received had he or she let the policy mature.
The information provided in this blog post is for educational purposes only, and should not be solely relied upon. Should you require assistance in determining how to proceed with a current annuity your client has contact Krause Financial Services to obtain advisement specific to your client's needs.