1035 Exchange Rules for Annuities

Maybe you already own an annuity, but now you’ve heard of a new one that would give you a better rate of return.

The problem is that withdrawing cash from an annuity incurs taxes.

But what if there was a solution?

How Does a 1035 Exchange Work?

Also known as a like-kind exchange, a 1035 exchange annuity changeover allows you to exchange one annuity for another – without incurring taxes or early withdrawal costs.

Without a 1035, the cost of an annuity exchange includes as much as 37% federal tax, state tax if applicable, and the insurance company demanding a surrender fee of at least 7%. If you’re younger than 59½, the IRS will also want around 10%.

You’ll save a ton of money by avoiding these fees through a 1035 exchange.

IRS Requirements for Transfers

Section 1035 of the Internal Revenue Code adds some conditions to the process.

Most types of investment can only be exchanged for another of the same type. The code permits life insurance to be exchanged for an annuity, but not the reverse (which would be open to fraud).

The cost basis of the old policy becomes the cost basis for the new one. Unless the two policies are both offered by the same company, the process must be reported in detail to the IRS – with your personal taxes – on Form 1099-R.

Due to the tax-deferred nature of the 1035 exchange process, annuity changeovers protect you, the policy owner, from premature tax – but the state still gets revenue.

What Is Not Allowed by the IRS

By the terms of the Internal Revenue Code, you as the policy owner cannot take “constructive receipt” of an annuity, and use this to purchase a new annuity.

Instead, the roll-over must occur directly.

Additionally, according to the rules of a 1924 exchange, annuity holders must remain the same. If you wish to do an exchange and transfer the policy, you’ll have to do the changeover, and then transfer one’s policy to someone else.

Exchanges between qualified accounts, such as a 401(k) and an IRA, are not subject to this section of the code.

Pitfalls of a 1035 Exchange

A 1035 exchange can be a means to swap out an old, mediocre policy for a new, more rewarding one. But there is more to annuities than the amount you get out.

A new policy that exposes you to more risk may not be the best fit for your particular retirement needs. Furthermore, if the new policy leads to withdrawal and surrender charges, the apparent rewards of a 1035 exchange annuity switch-up may be a mirage.

Lastly, fees and administrative charges can eat into the value of your policy. Do your homework when choosing an insurance company, and only use those that are reputable.

Final Thoughts

Everyone’s needs are different, which means choosing the best annuities is difficult, if you are not an expert.

Soliciting advice from a professional is essential before making a major decision about your financial future.

If you’re stuck with an unsatisfactory annuity, ask a licensed financial planner if completing a 1035 exchange may be the right call for you.

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