You can exchange one retirement annuity for another, but you as a retiree need to watch out for what you may lose in the process. Often when you have one investment and see a similar but better version of it, you wonder if you can ‘upgrade’ to the new and improved version. Generally, whenever you liquidate an investment or retirement annuity, you need to pay taxes on any gain. If you buy another investment, your cost of the new investment will be its tax basis until it is sold in the future to determine gain.
However, in the case of two retirement annuities of ‘like kind’, the U.S. tax code, section 1035, allows you to simply exchange the two ‘like kind’ contrcats–if circumstances allow–so as not to have to pay tax until the latter investment is sold or pays out. In the case of retirement annuities, you need to be aware of what/how your ‘new and improved’ annuity may be different from your ‘old’ annuity.
Section 1035 allows you to exchange an existing annuity contract for a new annuity contract without paying any tax on the income and investment gains in your current retirement annuity. These tax-free exchanges, known as 1035 exchanges, can be useful if another annuity has features that you prefer, such as a larger death benefit, different annuity pay-out options, or a wider selection of investment choices.
You may, however, be required to pay surrender charges on the old retirement annuity if you are still in its surrender charge period. In addition, a new surrender charge period generally begins when you exchange into the new annuity. This means that, for a significant number of years (as many as 10 years); you typically will have to pay a surrender charge (which can be as high as 9% of your purchase payments) if you withdraw funds from the new annuity prior to term, and if the withdrawals exceed the annual allowance.
Further, the new retirement annuity may have higher annual fees and charges than the old annuity, which will reduce your returns.
So if you are thinking about a 1035 exchange, compare both retirement annuities carefully. Unless you plan to hold the new annuity for a significant amount of time, you may be better off keeping the old annuity because the new annuity typically will impose a new surrender charge period.
Also, if you decide to do a 1035 exchange with your retirement annuity, get the right retirement help and talk with a qualified tax professional to make sure you don’t violate the provisions of IRS section 1035. While insurance agents sell retirement annuities, few are well schooled in the more esoteric tax aspects.
Note: Annuities once annuitized cannot be surrendered for value. Income from retirement annuities is taxed as ordinary income and withdrawals prior to age 59½ are subject to a 10% penalty. Income from annuitization is taxed partly as ordinary income and partly as return of capital. The purchase of annuities incurs commissions and potential surrender charges. Any guarantees are based on the claims-paying ability of the insurance company. Retirement annuities should be considered long-term investments.
Learn the truth about annuities. If you own an annuity or are thinking about investing, get a copy of this booklet first!